SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
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Commission File Number 0-23629
Happy Kids Inc.
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(Exact Name of Registrant as Specified in Its Charter)
New York 13-3473638
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(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
100 West 33rd Street, Suite 1100, New York, New York 10001
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(Address of Principal Executive Offices) (Zip Code)
(212) 695-1151
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of Each Exchange on Which Registered
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None
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Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value
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(Title of Class)
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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:
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|
State the aggregate market value of the voting common stock held by
non-affiliates of the registrant: $28,146,250 at March 15, 1999 based on the
last sales price on that date.
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of March 15, 1999:
Class Number of Shares
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Common Stock, $0.01 par value 10,280,000
The following documents are incorporated by reference into the Annual
Report on Form 10-K: Portions of the registrant's definitive Proxy Statement for
its 1999 Annual Meeting of Stockholders are incorporated by reference into Part
III of this Report.
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TABLE OF CONTENTS
Item Page
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PART I 1. Business....................................... 1
2. Properties..................................... 9
3. Legal Proceedings.............................. 9
4. Submission of Matters to a Vote of Security
Holders....................................... 9
PART II 5. Market for the Company's Common Equity
and Related Stockholder Matters............... 10
6. Selected Consolidated Financial Data........... 12
7. Management's Discussion and Analysis of
Financial Condition and Results of Operations.. 13
7A. Quantitative and Qualitative Disclosure
About Market Risk............................. 20
8. Financial Statements and Supplementary Data.... 20
9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure......... 20
PART III 10. Directors and Executive Officers of the
Company....................................... 21
11. Executive Compensation......................... 21
12. Security Ownership of Certain Beneficial
Owners and Management.......................... 21
13. Certain Relationships and Related Transactions. 21
PART IV 14. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K........................ 22
SIGNATURES......................................................... 23
EXHIBIT INDEX...................................................... 25
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS......................... F-1
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PART I
ITEM 1. BUSINESS.
GENERAL
Happy Kids Inc. ("Happy Kids" or the "Company") is a designer and marketer
of custom-designed, licensed and branded children's apparel. The Company
produces high-quality, coordinated apparel programs, including knit tops,
bottoms, overalls, shortalls, coveralls and swimwear, for newborns, infants,
toddlers, boys and girls (collectively, "playwear"). The Company's major
licenses include Nickelodeon's Rugrats, AND 1 and B.U.M. Equipment. The Company
also designs and delivers private label branded playwear programs for leading
retailers, such as Sesame Street for Kmart. The Company's strategy is to work
closely with its customers to design and market coordinated playwear programs
resulting in gross margins that the Company believes are higher than those
typically generated from sales of non-licensed or non-private label branded
playwear.
In 1995, to leverage its customer relationships, its popular licenses and
brand names and its reputation for quality products and reliable delivery, the
Company initiated its current sales strategy under which customers order
specific quantities of goods on a fixed-price basis three to nine months in
advance of a selling season. For 1998, substantially all of the Company's
apparel was produced upon receipt of customer orders. Based upon orders received
as of December 31, 1998, the Company had backlog of $123.5 million, which it
expects to fill over the following three to nine months. However, in recent
months subsequent to the year ended December 31, 1998, the Company has
experienced a significant increase in orders involving a rapid turnaround from
the date the order is placed to the shipment date.
Also in 1995, the Company began focusing on the development of a
diversified portfolio of popular, established and well-recognized licensed
properties and branded private label arrangements. Consequently, the Company has
shifted its product mix to higher margin licensed and private label apparel
programs from lower margin house brands. As a result of this change in product
mix combined with the implementation of the Company's sales strategy, net sales
and gross margins increased as follows:
Net Sales Gross Margins
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1998 $154.6 million 26.4%
1997 $106.7 million 25.2%
1996 $ 90.7 million 23.0%
1995 $ 79.8 million 18.5%
Additionally, the Company has been able to leverage the popularity and
goodwill associated with its licensed properties and brand names to promote
sales, rather than undertaking costly marketing initiatives.
The Company's playwear is designed by over 50 in-house designers and
graphic artists organized in teams dedicated to each of the Company's licensed
properties and private label programs. Each team works closely with licensors,
customers and contract manufacturers,
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utilizing state-of-the-art CAD systems, to design coordinated products featuring
textured fabrications and detailed graphics. The Company believes that its
customers rely on its ability to design, have manufactured and deliver on a
timely basis commercially successful apparel programs. The Company markets its
playwear primarily to mass-market retailers, mid-tier distributors and
department stores, including Kmart, Target and WalMart.
The Company's products are manufactured to exacting quality standards and
specifications by over 75 unaffiliated, foreign and domestic contract
manufacturers. The Company uses third-party manufacturers to eliminate the
significant capital investment requirements associated with maintaining
manufacturing facilities. The Company has developed long-standing relationships
with many of its contract manufacturers. The Company's ability to design and
have manufactured high-quality playwear is evidenced by the Company's product
return rates of 2.0% and 1.9% in 1998 and 1997, respectively.
The Company's growth strategy is to continue to leverage the strength of
its diversified portfolio of licensed properties, private label relationships
and the quality of its playwear products. The key elements of this strategy
include:
o to increase sales to existing accounts by expanding product categories
and sizes incorporating the Company's existing licensed properties and
private label relationships;
o to expand the Company's customer base by selling to additional
mass-market retailers, mid-tier distributors, department stores,
specialty retailers and sporting goods chains;
o to leverage newly acquired licensed properties and private label
relationships; and
o to add new licenses and private label relationships based on
established and popular brands.
REORGANIZATION
The Company was incorporated in 1988 in New York under the name O'Boy Inc.
and changed its name to Happy Kids Inc. in December 1997. Historically, the
Company operated as separate business entities, with the first of such entities
commencing business operations in 1979, all under the common ownership of the
principal shareholders of the Company, consisting of Messrs. Jack M. Benun, the
Company's Chairman of the Board, President and Chief Executive Officer, Mark J.
Benun, the Company's Executive Vice President and Secretary, and Isaac Levy, the
Company's Senior Vice President. On April 1, 1998, immediately prior to the
effectiveness of the Company's initial public offering on April 2, 1998 (the
"IPO"), all of such separate entities became wholly-owned subsidiaries of the
Company. The Company issued 4,262,500 shares of Common Stock to such
shareholders in exchange for their ownership of these separate business
entities. All share and per share amounts throughout this Form 10-K have been
restated to retroactively reflect such reorganization.
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PRODUCTS AND LICENSES
The Company's playwear products are designed and marketed as coordinated
apparel programs and include knit tops, bottoms, overalls, shortalls, coveralls
and swimwear. The Company's products are marketed in a variety of size
categories including newborns, infants, toddlers (2T-4T), boys (4-7 and 8-20)
and girls (4-6x and 7-16). The following is a description of the Company's
current apparel programs:
<TABLE>
<CAPTION>
EXISTING LICENSED AND BRANDED CURRENT SIZE
APPAREL PROGRAMS DESCRIPTION CURRENT DISTRIBUTION CHANNELS OFFERINGS
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<S> <C> <C> <C>
AND 1........................... Basketball apparel Top-line specialty athletic Toddlers, boys
retailers, mid-tier athletic
retailers and full-price
department stores with athletic
concept shops
B.U.M. Equipment................ Lifestyle activewear Mass-market retailers, Newborns, infants,
mid-tier distributors toddlers, boys, girls
Canyon River Blues for Sears.... Activewear Sears Infants, toddlers, boys
(4-7), girls (4-6x)
E.N.U.F. Internationale......... Lifestyle activewear Mid-tier distributors, Boys, girls
department stores
First Moments for Kohls......... Infantwear Kohls Newborns, infants
Lullaby Club for Target......... Infantwear Target Newborns, infants
New Legends for Kids R Us....... Activewear Kids R Us Toddlers, girls
Nickelodeon's Rugrats........... Character-based Mass-market retailers, Boys, girls
activewear mid-tier distributors,
department stores
Sesame Street for Kmart......... Character-based Kmart Infants, toddlers, boys
activewear (4-7), girls (4-6x)
Warner Brothers' Scooby Doo..... Character-based Mid-tier distributors, Boys, girls
activewear mass-market retailers
World Wrestling Federation...... Character-based Mass-market retailers, mid-tier Boys
apparel distributors, department
stores, specialty retailers
NEW LICENSED AND BRANDED
APPAREL PROGRAMS DESCRIPTION ANTICIPATED DISTRIBUTION CHANNELS ANTICIPATED LAUNCH (1)
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Arthur.......................... Character-based Mid-tier distributors, Fall 1999
activewear department stores
Jim Henson's Kermit the Frog
and Friends..................... Character-based Mass-market retailers, mid-tier Holiday 1999 (2)
activewear distributors, department stores
MECCA........................... Activewear Mid-tier distributors, Holiday 1999
department stores
MUDD............................ Sportswear Mid-tier distributors, Holiday 1999
department stores
Teletubbies..................... Character-based Mass-market retailers, mid-tier Fall 1999
activewear distributors, department stores
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(1) Initial sales of such products are expected to occur subsequent to December 31, 1998.
(2) The Company has negotiated a deal with Kmart to launch such license exclusively with Kmart.
</TABLE>
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The Company's current licensing arrangements contain initial terms of
between eighteen months and five years, and typically include multiple renewal
options of between one and five years, subject to certain conditions. The
present terms of the Company's current license arrangements will expire between
December 1999 and May 2003. The Company's licenses generally require an
initiation fee and/or minimum annual royalties to be recouped from ongoing
royalty payment obligations, which currently range from 6.0% to 12.0% of the
Company's net sales of products incorporating a licensed property. Apparel
industry licenses typically are granted with respect to product categories,
sizes and channels of distribution, and may be either exclusive or
non-exclusive. Virtually all of the licenses are non-assignable without the
consent of the licensors and may be terminated by the licensor upon a change of
control of the Company. The Company's private label relationships are conducted
on a purchase order basis, rather than pursuant to contract. Net sales by the
Company for 1998 attributable to its licensing or private label arrangements for
Nickelodeon's Rugrats, B.U.M. Equipment, AND 1 and Sesame Street for Kmart
accounted for 20.2%, 14.4%, 14.1% and 17.8% of net sales, respectively. Net
sales by the Company for 1997 attributable to its licensing or private label
arrangements for B.U.M. Equipment, Nickelodeon's Rugrats, Ocean Pacific and
Sesame Street for Kmart accounted for 18.9%, 11.3%, 11.1% and 14.3% of net
sales, respectively. No other licensing or private label arrangements accounted
for more than 10% of the Company's net sales in either 1998 or 1997.
MERCHANDISING
Design
The Company's playwear products are designed by over 50 in-house designers
and graphic artists organized in teams dedicated to each of the Company's
licensed properties and private label programs. Each team works closely with
licensors, customers and contract manufacturers, utilizing state-of-the-art CAD
systems, to design coordinated products featuring textured fabrications and
detailed graphics. The Company believes that its customers rely on its ability
to design, have manufactured and deliver on a timely basis commercially
successful apparel programs.
The design process incorporates product design, merchandising, sourcing and
production. The Company's design and merchandising teams continually monitor and
evaluate the children's playwear market for styles and trends in fabrics, trims
and accessories, as well as analyze online sales information provided by its
customers. In conjunction with its customers and licensors, the Company's design
teams identify specific design needs and develop product programs. The Company
oversees all garment production, including pattern development and color and
sample approval, through regular communication with the Company's customers and
contract manufacturers.
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Sales and Marketing
The Company markets and distributes its products through four channels of
distribution, including mass-market retailers, mid-tier distributors, department
stores and specialty retailers, including sporting goods chains. All of the
Company's sales are within the United States. Recently, the Company began
exploring strategies to exploit the growing trend of electronic commerce,
including seeking to expand certain of its licenses to permit internet sales as
a channel of distribution and engaging a website design firm. The Company's
customers include:
MASS-
MARKET MID-TIER DEPARTMENT SPECIALTY
RETAILERS DISTRIBUTORS STORES RETAILERS
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Kmart Kids R Us Dayton Hudson Champs
Target Price/Costco Federated Department FootAction
Stores
WalMart Sears JC Penney Foot Locker
Kohls Dillards
In 1995, to leverage its customer relationships, its popular licenses and
brand names and its reputation for quality products and reliable delivery, the
Company initiated its current sales strategy under which customers order
specific quantities of goods on a fixed-price basis three to nine months in
advance of a selling season. For 1998, substantially all of the Company's
apparel was produced upon receipt of customer orders. Additionally, the Company
has been able to leverage the popularity and goodwill associated with its
licenses and brand names to promote sales, rather than undertaking costly
marketing initiatives.
As of December 31, 1998, the Company maintained a sales and marketing staff
of 23 people, including its senior management. The Company is organized in
account teams led by key account sales executives. Each account sales executive
reports directly to senior management and is responsible for the day to day
customer relationship management and for supervising and monitoring the sales
staff. The Company's sales staff is compensated on a salary plus commission
basis.
The Company's sales and marketing staff works closely with the Company's
designers and graphic artists throughout the design and production process. The
Company's customers often launch a new product line associated with a new
license or private label relationship in a limited number of stores. If the
product is successful, the Company's customers often market the product line
throughout their retail chains or in a significantly larger number of stores.
The Company's design team and sales staff work closely with its customers to
monitor, review and analyze product launches.
5
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The Company's customer base has been and continues to be highly
concentrated. Sales of the Company's products to each of Kmart, Target and
WalMart accounted for approximately 22.3%, 14.0% and 11.4% of net sales for
1998, respectively. Sales of the Company's products to each of Price/Costco,
Kmart and Kids R Us accounted for approximately 17.4%, 14.3% and 11.0% of net
sales for 1997, respectively. Based upon historical and recent results and
existing relationships with customers, the Company believes that a substantial
portion of its net sales and gross profits will continue to be derived from a
small number of large customers. There can be no assurance that the Company's
larger customers will continue to place orders with the Company or that orders
by such customers will continue at their previous levels.
MANUFACTURING
Contract Manufacturers
The Company's products are manufactured to exacting quality standards and
specifications by over 75 unaffiliated, foreign and domestic contract
manufacturers. The Company uses third-party manufacturers to eliminate the
significant capital investment requirements associated with maintaining
manufacturing facilities. For 1998 and 1997, foreign manufacturers produced
approximately 86.2% and 93.4% of the Company's products, respectively, with the
remainder of products produced domestically.
The Company works with independent buying agents in five countries to
assist the Company in selecting a contract manufacturer. The Company and such
buying agents review, among other things, quality of merchandise produced, the
ability of such manufacturer to meet the Company's timing requirements for
delivery and price. The Company is not a party to long-term contractual or other
arrangements with any manufacturer and often uses more than one manufacturer to
produce a coordinated apparel program. The Company believes that it has ready
access to numerous contract manufacturers and that its existing contract
manufacturers have the ability to manufacture across several product lines.
During 1998 and 1997, various production facilities located in Thailand
accounted for an aggregate of 43.1% and 41.4% of the Company's manufactured
products, respectively, and various production facilities in Hong Kong accounted
for an aggregate of 29.1% and 30.7% of the Company's manufactured products,
respectively. No other country accounted for 10% or more of the Company's
manufactured products during 1998 or 1997. In addition, a manufacturing facility
located in Hong Kong accounted for 17.7% of the Company's manufactured products
during 1998 and 12.6% in 1997. In addition, another facility in Hong Kong
accounted for 10.6% of the Company's manufactured products during 1997. No other
single manufacturer accounted for 10% or more of the Company's manufactured
products during 1998 or 1997.
The Company's products are subject to bilateral textile agreements between
the United States and a number of foreign countries. Such agreements, which have
been negotiated under the framework established by the Arrangement Regarding
International Trade in Textiles, allow the United States to impose restraints at
any time on the importation of categories of merchandise that, under the terms
of the agreements are not currently subject to specified limits. The Company
does not own the right to import finished garments into the United States, but
relies on its
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contract manufacturers to obtain the necessary quotas. In the past, to the
extent that necessary import quotas have not been available with respect to a
particular source of supply, the Company has been able to find an alternative
source of supply. Accordingly, the availability of quotas has not had a material
effect upon the Company's business, financial condition or results of
operations. The Company's continued ability to source products that it imports
may be adversely affected by a significant decrease in available import quotas
as well as any additional bilateral agreements or unilateral trade restrictions.
In addition, a significant portion of the Company's products are manufactured in
Hong Kong. China recently resumed sovereignty over Hong Kong. The Company cannot
predict the effect, if any, this event will have on its contract manufacturers
in Hong Kong and there can be no assurance that Hong Kong will not experience
political, economic or social disruption as a result of the resumption of
Chinese sovereignty. In addition, there have been a number of recent trade
disputes between China and the United States during which the United States has
threatened to impose tariffs and duties on some products imported from China and
to withdraw China's "most favored nation" trade status. The loss of such status
for China, changes in current tariff structures or the adoption by the United
States of trade policies or sanctions adverse to China could have a material
effect on the Company's business, financial condition or results of operations.
The principal raw materials used in the production and sale of the
Company's products are yarn, fabric, trim, buttons and other accessories. Raw
materials are purchased by the manufacturers who deliver finished goods to the
Company. The Company believes that an adequate supply of raw materials used in
the manufacture of its products is readily available from existing and
alternative sources at reasonable prices.
Quality Control
The Company has in place comprehensive quality control procedures to ensure
that fabrics, materials and finished goods meet the Company's exacting quality
standards. The Company utilizes both internal and independent quality control
representatives to monitor contract manufacturers' production processes. In
addition, certain of the Company's buying agents engage their own personnel who
monitor compliance with the Company's quality control specifications.
The Company oversees testing of yarns and trim for colorfastness,
washability and other standards before sample garments are produced. Selected
product samples are sent to independent testing facilities which test garments
for colorfastness, washability, size specifications and other standards. Sample
garments are randomly subjected to similar quality control tests by the Company
for fit and appearance. Foreign and domestic contract manufacturers are
routinely visited on a spot check basis to ensure compliance with the Company's
quality standards. Finished garments are subject to final inspection in the
Company's warehouse for general appearance and quality prior to shipment to
customers. Prior to shipment, inspection certificates are issued to indicate
that the products have been inspected and found to be in conformity with the
order. Products which are manufactured in foreign countries are tested to ensure
that such products meet United States customs import requirements by the foreign
manufacturers prior to shipment, and the results of such tests, along with
samples of each product style, are sent to the Company.
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The Company's ability to design and have manufactured high-quality playwear is
evidenced by the Company's product return rates of 2.0% and 1.9% in 1998 and
1997, respectively.
DISTRIBUTION
Upon completion of the manufacturing process, the Company's products are
shipped from the contract manufacturers by sea, air or land to the Company's
domestic warehouse facilities. The Company utilizes its warehouse facilities in
New Brunswick, New Jersey, or its public warehouse arrangement in Long Beach,
California prior to shipping its products directly to its customers' stores or
distribution centers via common carrier.
INDUSTRY AND COMPETITION
The children's playwear industry is highly competitive and fragmented. The
Company competes with many companies engaged in the design, production and
distribution of children's apparel for newborns, infants, toddlers, boys and
girls. Some of the Company's competitors have longer operating histories and
financial, sales, marketing, design capabilities and other competitive resources
which are substantially greater than those of the Company. The Company also
faces competition from its existing customers, who may themselves begin to
produce children's playwear directly. In addition, such customers have in the
past competed, and may continue in the future to compete, for available branded
programs. Further, to the extent that the Company's customers or competitors
maintain or initiate private label programs, such customers or competitors will
compete with the Company's licensed and branded properties. The Company also
competes with other manufacturers of children's apparel for retail floor space.
The Company believes that the principal competitive factors affecting its
business include:
o the ability to deliver, on a timely basis, high quality coordinated
playwear apparel;
o the ability to successfully obtain licensing arrangements and private
label relationships based on characters and brands that are appealing
to children and parents;
o the ability to successfully design coordinated apparel programs based
on such licensing arrangements and relationships; and
o the ability to produce playwear at competitive prices.
EMPLOYEES
As of December 31, 1998, the Company employed 172 persons, consisting of 23
in sales and marketing, 69 in design and graphic arts, 48 in warehousing and
distribution and 32 in finance, administration and management. Twenty eight of
the Company's 48 employees at its New Brunswick, New Jersey warehouse facility
are subject to a collective bargaining agreement (the
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"Collective Bargaining Agreement") between Hawk Industries, Inc. ("Hawk"), a
wholly-owned subsidiary of the Company, and Journeymen's and Production Allied
Services of America and Canada International Union, Local No. 157 (the "Union").
The initial term of such Collective Bargaining Agreement began on August 1, 1996
and extends to July 31, 1999, and shall continue thereafter from year to year,
unless terminated or modified by written notice within certain time periods.
Pursuant to the Collective Bargaining Agreement, the Company must, among other
obligations, recognize the Union as the exclusive representative of all of the
employees covered under the Collective Bargaining Agreement, endeavor to seek
all employment, new or otherwise, through the Union, require all employees of
Hawk, as a condition to employment, to become members of the Union within a
specified time period and maintain specified hours of work. The Collective
Bargaining Agreement also contains terms governing, among other things,
overtime, holidays, vacations, leave of absence, rest periods, safety and
health, strikes and lockouts, wages, grievance procedures and health and welfare
plans. The Company has not had any significant work stoppages and considers its
relations with its employees to be good.
ITEM 2. PROPERTIES.
The Company currently leases all of its office space. The Company leases
approximately 23,000 square feet for its executive offices and showroom located
at 100 West 33rd Street, New York, New York. Such lease expires in September
2005 and contains renewal options for an additional three and one half years.
The Company also leases approximately 130,000 square feet for warehousing and
distribution at its warehouse facility in New Brunswick, New Jersey. Such lease
expires in March 2000 and contains renewal options for two additional five year
terms. The Company also maintains a small showroom in Bentonville, Arkansas. The
Company believes that its facilities are sufficient to meet current needs for
its sales, marketing, design, administrative, warehousing and distribution
requirements.
ITEM 3. LEGAL PROCEEDINGS.
The Company is not a party to any material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
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PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.
Prior to April 1998, there was no established market for the Company's
Common Stock. Since April 2, 1998, the Common Stock has traded on the Nasdaq
National Market ("NNM") under the symbol "HKID."
The following table sets forth the high and low bid information for the
Common Stock for each of the quarters since the quarter ended June 30, 1998 as
reported on the NNM. Such quotations reflect inter-dealer prices, without retail
mark-up, mark-down or commission and may not represent actual transactions.
QUARTER ENDED HIGH LOW
----------------------------------------------------------------
June 30, 1998........... $ 14.75 $ 10.50
(from April 2, 1998)
September 30, 1998...... $ 14.00 $ 7.375
December 31, 1998....... $ 13.625 $ 7.125
As of March 15, 1999, the approximate number of holders of record of the
Common Stock was 22 and the approximate number of beneficial holders of the
Common Stock was 839.
The Board of Directors intends to retain any earnings of the Company to
support operations and to finance expansion and does not intend to pay cash
dividends on the Common Stock in the foreseeable future. Any future
determination as to the payment of dividends will be at the discretion of the
Board of Directors, and will depend on the Company's financial condition,
results of operations, capital requirements and such other factors as the Board
of Directors deems relevant. The Company also currently is restricted by the
terms of its credit facility from paying cash dividends on its Common Stock.
The Company and certain of its subsidiaries had been treated for federal
and state income tax purposes as S Corporations under Sub-chapter S of the
Internal Revenue Code of 1986, as amended, since 1988. As a result of such S
Corporation status, the then current shareholders of each such entity
(consisting solely of the shareholders of each such entity immediately prior to
the effectiveness of the IPO), rather than such entities, had been taxed
directly on earnings for federal and certain state income tax purposes, whether
or not such earnings were distributed. Immediately prior to the effectiveness of
the IPO, each such entity terminated its status as an S Corporation and since
then has been subject to federal and state income taxes at applicable C
Corporation rates.
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Prior to the termination of such S Corporation status, each such entity
declared an S Corporation distribution to the shareholders of record on the date
of such declaration. Such shareholders consisted solely of Messrs. Jack M.
Benun, the Company's Chairman of the Board, President and Chief Executive
Officer, Mark J. Benun, the Company's Executive Vice President and Secretary,
and Isaac Levy, the Company's Senior Vice President with respect to the Company,
and solely of Jack Benun and Mark Benun with respect to each such subsidiary.
Such distribution, amounting to $7.6 million, represented substantially all of
the remaining undistributed S Corporation earnings of each such entity and is
evidenced by four-year 5.7% promissory notes issued to such shareholders in
connection with the termination of S Corporation status. Of this amount, $2.0
million (distributed evenly to the three shareholders) of the net proceeds from
the Company's IPO was used to make a partial payment of amounts due under such
notes. The balance of such S Corporation distributions will be paid in
accordance with the terms and provisions of such promissory notes and provide
for the timely distribution of amounts necessary to pay personal income taxes of
the shareholders due on amounts earned by the S Corporations for the period
January 1, 1998 through the termination of S Corporation status. In addition to
amounts paid pursuant to the promissory notes, $314,000 was distributed to the
aforementioned shareholders in 1998 in the form of dividends to fund their tax
liabilities resulting from such S Corporation status.
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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
The following table sets forth selected consolidated historical financial
data of the Company as of the dates and for the periods indicated. The selected
balance sheet data set forth below for the Company as of December 31, 1997 and
1998 and the selected statement of operations data for each of the years in the
three year period ended December 31, 1998 are derived from the audited financial
statements included elsewhere herein. The selected balance sheet data set forth
below for the Company as of December 31, 1994, 1995 and 1996 and the selected
statement of operations data for each of the years ended December 31, 1994 and
1995 are derived from the audited financial statements not included elsewhere
herein. The selected consolidated financial information is qualified in its
entirety by, and should be read in conjunction with, the Consolidated Financial
Statements and the Notes and "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations" which are included elsewhere in
this Annual Report on Form 10-K.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1994 1995 1996 1997 1998
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(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
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STATEMENT OF OPERATIONS DATA:
<S> <C> <C> <C> <C> <C>
Net sales......................... $74,520 $79,828 $90,723 $106,673 $154,559
Gross profit...................... 15,276 14,792 20,837 26,925 40,763
Operating expenses................ 12,320 14,816 15,370 18,457 22,449
------- ------- ------- -------- --------
Operating income (loss)........... 2,956 (24) 5,467 8,468 18,314
Interest expense, net............. 1,631 2,375 2,980 3,803 2,077
------- ------- ------- -------- --------
Income (loss) before pro forma
income taxes..................... 1,325 (2,399) 2,487 4,665 16,237
Pro forma net income(1)........... $ 703 $(1,463) $ 1,497 $ 2,704 $ 9,580
======= ======= ======= ======== ========
Pro forma basic net income per
share............................ $ 0.09 $ (0.19) $ 0.19 $ 0.35 $ 1.00
======= ======= ======= ======== ========
Pro forma diluted net income per
share........................... $ 0.09 $ (0.19) $ 0.19 $ 0.35 $ 0.99
======= ======= ======= ======== ========
Pro forma weighted average
shares outstanding - basic....... 7,750 7,750 7,750 7,750 9,625
======= ======= ======= ======== ========
Pro forma weighted average
shares outstanding - diluted..... 7,750 7,750 7,750 7,750 9,637
======= ======= ======= ======== ========
1994 1995 1996 1997 1998
-------------------------------------------------------
BALANCE SHEET DATA:
Working capital................... $ 5,942 $ 3,260 $ 5,228 $ 6,419 $ 36,295
Total assets...................... 27,570 33,568 33,986 44,952 50,452
Due to bank....................... 14,435 21,340 19,732 24,863 3,753
Due to shareholders............... 1,200 1,500 1,560 1,400 5,719
Capital lease obligations......... 14 52 123 68 27
Shareholders' equity.............. 6,135 3,848 5,573 6,644 32,531
</TABLE>
- ------------
(1) Prior to April 2, 1998, the Company had operated as an S Corporation for
federal and New York state income tax purposes since 1988. Two of the
wholly-owned subsidiaries are C Corporations and, accordingly, have been taxed
at the appropriate corporate federal and state tax rates. The historical
Consolidated Financial Statements do not include a provision for federal and
state income taxes for such periods for those subsidiaries which had elected to
be treated as S Corporations. A provision for state income taxes has been made
for those states not recognizing S Corporation status. Pro forma net income has
been computed as if the Company had been fully subject to federal and state
income taxes based on the tax laws in effect during the respective periods. See
Notes A and K to the Consolidated Financial Statements.
12
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
OVERVIEW
Happy Kids is a designer and marketer of custom-designed, licensed and
branded children's apparel. The Company produces high-quality, coordinated
apparel programs, including knit tops, bottoms, overalls, shortalls, coveralls
and swimwear, for newborns, infants, toddlers, boys and girls (collectively,
"playwear"). The Company's major licenses include Nickelodeon's Rugrats, AND 1
and B.U.M. Equipment. The Company also designs and delivers private label
branded playwear programs for leading retailers, such as Sesame Street for
Kmart. The Company's strategy is to work closely with its customers to design
and market coordinated playwear programs resulting in gross margins that the
Company believes are higher than those typically generated from sales of
non-licensed or non-private label branded playwear.
Prior to and including much of 1995, the Company's operating strategy
primarily focused on developing and marketing its own house brands. The Company
manufactured products for inventory under the Company's brands and often
concentrated on enhancing sales volume rather than focusing on a combination of
sales volume and gross margins. The Company believes that the loss it incurred
in 1995 was primarily attributable to these factors. In 1995, to leverage its
strong customer relationships, the Company initiated its current sales strategy
under which the Company's customers order specific quantities of goods on a
fixed-price basis three to nine months in advance of a selling season. As a
result, for 1997 and for 1998, substantially all of the Company's playwear was
produced upon receipt of customer orders. Also in 1995, the Company elected to
concentrate on developing a diversified portfolio of popular, established and
well-recognized licensed properties and private label relationships and
de-emphasized its reliance on house brands, which have been a declining
component of the Company's net sales in each year since 1995. Since that time,
the Company's strategy has been to work closely with its customers to design and
market high-quality coordinated apparel programs resulting in gross margins that
the Company believes are higher than those typically generated from sales of
non-licensed or non-private label branded playwear.
Statements contained or incorporated by reference in this Annual Report on
Form 10-K that are not based on historical facts are "forward-looking
statements" within the meaning of Section 21E of the Securities Exchange Act of
1934, as amended, including, without limitation, statements regarding the
Company's sales strategy, concentration on the development of a diversified
portfolio of licensed properties and private label relationships and gross
margins. Forward-looking statements also may be identified by the use of
forward-looking terminology such as "may", "will", "expect", "estimate",
"anticipate", "continue", or similar terms, variations of such terms or the
negative of those terms. This Form 10-K contains forward-looking statements that
involve risks and uncertainties, including, but not limited to, those related
to: (i) general economic conditions; (ii) a dependence on license arrangements;
(iii) a dependence on private label relationships; (iv) a dependence on contract
manufacturers; (v) a reliance on key customers; (vi) a dependence on access to
credit facilities; (vii) the risks associated with significant growth; (viii)
competition; (ix) seasonality of sales; (x) cyclicality and trends in the
13
<PAGE>
apparel industry; (xi) import restrictions and other risks associated with
international business; and (xii) risks relating to the Company's Year 2000
compliance and the Year 2000 compliance of the Company's contract manufacturers,
suppliers, distributors, marketing partners and certain other parties. The
Company's actual results may differ materially from the results discussed in the
forward-looking statements contained herein.
The following discussion should be read in conjunction with the
consolidated financial statements and notes appearing elsewhere in the Annual
Report on Form 10-K.
RESULTS OF OPERATIONS
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997
Net Sales. Net sales increased $47.9 million, or 44.9%, to $154.6 million
in 1998 from $106.7 million in 1997. The increase in net sales is attributable
primarily to increased sales of playwear incorporating the properties covered by
the Company's licenses with Nickelodeon's Rugrats, AND 1, B.U.M. Equipment, and
increased sales to Kmart resulting from its Sesame Street private label program.
This increase was partially offset by lower sales in two of the Company's
licenses that are no longer active.
Gross Profit. Gross profit increased by $13.8 million, or 51.4%, to $40.8
million in 1998 from $26.9 million in 1997. Due to improved sales mix, the gross
profit margin increased to 26.4% in 1998 from 25.2% in 1997. In addition, the
1997 gross margin amount includes $758,000 in income due to a decrease in LIFO
reserves, which accounted for .03% of such gross margin, while the 1998 gross
margin amount includes $181,000 in income due to a decrease in LIFO reserves,
which had no effect on gross margin for the year.
Operating Expenses. Operating expenses increased by $4.0 million, or 21.6%,
to $22.4 million in 1998 from $18.5 million in 1997. Operating expenses consist
entirely of selling, design and shipping expenses, and general and
administrative expenses.
Selling, Design and Shipping Expenses. Selling, design and shipping
expenses increased by $2.4 million, or 21.1%, to $13.7 million in 1998 from
$11.3 million in 1997. This increase is attributable primarily to higher
sales compensation, warehousing and shipping costs associated with
increased sales volumes. In addition, advertising expenses increased due to
cooperative advertising charges from a licensor associated with a major
licensing program. Also, design and production salaries and sampling costs
increased as a result of the Company's expanded product lines. As a
percentage of net sales, selling, design and shipping expenses decreased to
8.9% in 1998 from 10.6% in 1997.
General and Administrative Expenses. General and administrative
expenses increased $1.6 million, or 22.5%, to $8.8 million in 1998 from
$7.2 million in 1997. This increase is primarily the result of higher
factor commissions associated with increased sales volume, as well as
higher professional and data processing expenses offset somewhat by reduced
officers' compensation implemented in the first quarter of 1998. As a
percentage of net sales, general and administrative expenses decreased to
5.7% in 1998 from 6.7% in 1997 due to the operating leverage associated
with the higher sales.
14
<PAGE>
Interest Expense, net. Interest expense, net, decreased $1.7 million, or
45.4%, to $2.1 million in 1998 from $3.9 million in 1997. This decrease is a
result of the application of a substantial portion of the proceeds from the
Company's initial public offering to the repayment of the Company's bank debt in
the second quarter of 1998, as well as a decrease in interest rates and
associated lending fees in 1998. As a percentage of net sales, interest expense
decreased to 1.3% for 1998, as compared to 3.6% in 1997.
Income Before Income Taxes. Income before income taxes increased $11.6
million, to $16.2 million in 1998 from $4.7 million in 1997 due to the reasons
described above. As a percentage of net sales, income before income taxes
increased to 10.5% in 1998 from 4.4% in 1997. In connection with the Company's
initial public offering, effective April 2, 1998, the Company changed from an S
Corporation to a C Corporation. This resulted in an increase in current taxes
offset by a deferred tax asset recognized upon conversion to the C Corporation
status.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Net Sales. Net sales increased $16.0 million, or 17.6%, to $106.7 million
in 1997 from $90.7 million for 1996. The increase in net sales was attributable
primarily to increased sales of playwear incorporating the properties covered by
the Company's Rugrats license with Nickelodeon and increased sales to Kmart
resulting in part from the 1997 commencement of its Sesame Street private label
program. This increase was partially offset by a decrease in net sales of
products incorporating properties covered by one of the Company's former major
licenses, which license currently represents only a small percentage of net
sales.
Gross Profit. Gross profit increased by $6.1 million, or 29.2%, to $26.9
million in 1997 from $20.8 million in 1996. The gross profit margin increased to
25.2% in 1997 from 23.0% in 1996. The increase in the gross margin was
attributable to the implementation of the Company's current sales strategy. As
part of such strategy, initiated in 1995, orders are received three to nine
months in advance of shipment resulting in finished goods being produced
according to customer order. Due to the timing of the order cycle and revenue
recognition (sales are recognized when products are shipped), the Company first
began to fully realize the benefits of such strategy in mid-1996. In addition,
during 1997, there was a decrease in the Company's product return rates as
compared to 1996. Gross profit is net of any royalties associated with the use
of licensed properties.
Operating Expenses. Operating expenses increased by $3.1 million, or 20.1%,
to $18.5 million in 1997 from $15.4 million in 1996. Operating expenses consist
entirely of selling, design and shipping expenses, and general and
administrative expenses.
Selling, Design and Shipping Expenses. Selling, design and shipping
expenses increased by $2.2 million, or 24.9%, to $11.3 million in 1997 from
$9.0 million in 1996. This increase was attributable primarily to higher
sales salaries and commissions for existing personnel and the hiring of
additional sales and design personnel during the year, as well as higher
travel, shipping and freight costs associated with increased sales volumes.
In addition, other design costs had increased as a result of the expansion
of the
15
<PAGE>
Company's production. As a percentage of net sales, selling, design
and shipping expenses increased to 10.6% in 1997 from 10.0% in 1996.
General and Administrative Expenses. General and administrative
expenses increased $839,000, or 13.3%, to $7.2 million in 1997 from $6.3
million in 1996. This increase was primarily the result of higher factor
commissions associated with increased sales volume, the hiring of
additional office personnel and normal annual salary rate increases. The
Company utilized its factoring arrangement for the entire year in 1997 as
compared to only ten months of the corresponding period in 1996. As a
percentage of net sales, general and administrative expenses decreased to
6.7% in 1997 from 7.0% in 1996.
Interest Expense, net. Interest expense, net increased $823,000, or 27.6%,
to $3.8 million in 1997 from $3.0 million in 1996. This increase is a result of
higher sales volume resulting in an increase in borrowings, interest expense and
fees under the line of credit. As a percentage of net sales, interest expense,
net increased slightly to 3.6% in 1997, from 3.3% in 1996.
Income Before Income Taxes. Income before income taxes increased $2.2
million, or 87.6%, to $4.7 million in 1997 from $2.5 million in 1996 due to the
reasons described above. As a percentage of net sales, income before income
taxes increased to 4.3% in 1997 from 2.7% in 1996.
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its cash requirements primarily through operations
and borrowings under its bank line of credit. Historically, the Company's
borrowing requirements have been seasonal, with peak working capital needs
arising during the first and third quarters.
On April 2, 1998, the Company consummated its IPO of 2,200,000 shares of
its Common Stock at a price of $10.00 per share, all of which shares were issued
and sold by the Company. On April 23, 1998, the Company consummated the exercise
of the underwriters' over-allotment option granted by the Company to the
underwriters in connection with the IPO. As a result, the Company issued and
sold an additional 330,000 shares of the Company's Common Stock at the IPO price
of $10.00 per share. The net proceeds to the Company from such sales were
approximately $22.3 million.
Of the total net proceeds received by the Company upon the consummation of
its IPO and the exercise of the over-allotment option, $2.0 million was
distributed to certain shareholders of the Company in connection with the
payment of a portion of the S Corporation distribution and the remaining amount
was utilized to pay down a portion of the outstanding balance under the
Company's credit line.
Through the consummation of the Company's IPO, the Company's credit line
permitted borrowings up to $42.0 million as a revolving credit line to expire on
December 31, 1998, subject to annual renewals (adjusted seasonally to $47.0
million from January 1, 1998 through April 30, 1998). The Company executed an
amendment of its existing credit line whereby upon effectiveness of the IPO and
satisfaction of certain conditions, the Company's credit line was
16
<PAGE>
amended to provide for a discretionary one year revolving line of credit,
renewable annually, providing for advances and letter of credit accommodations
up to the lesser of (a) $49.0 million through April 30, 1998, (b) $42.0 million
from May 1, 1998 through December 31, 1998, (c) $47.0 million from January 1,
1999 through March 31, 1999, or (d) at all times the sum of (i) up to
eighty-five percent of eligible accounts receivables, plus (ii) up to fifty
percent of finished goods inventory, plus (iii) overadvances approved by the
lender. The maximum amount of revolving credit advances outstanding at any time
could not exceed $35.0 million from January 1, 1998 to April 30, 1998 and $30.0
million thereafter, and the maximum amount of letters of credit outstanding at
any time may not exceed $35.0 million. The interest rate on amounts borrowed
will be the bank's then prevailing prime rate (7.75% at December 31, 1998). In
addition, in connection with the amendment to the credit line, personal
guarantees of certain of the Company's present shareholders under the credit
line terminated and the collateral pledged by such shareholders were released.
The credit line is collateralized by substantially all of the assets of the
Company. As of December 31, 1998 the Company had $3.8 million of outstanding
direct borrowings and $13.7 million of contingent liabilities under open letters
of credit. The Company's credit facility expires March 31, 1999. A new credit
line effective April 1, 1999 is currently being negotiated between the Company
and its lender. There can be no assurance that the new credit line will be
entered into, or if it is entered into, that it will be on terms at least as
favorable as the current credit line.
In addition, the Company's lender has sole discretion to make or withhold
advances under the credit line. There can be no assurance that the lender will
continue to lend under the credit line. If the lender exercises its discretion
to withhold advances, there would be a material adverse effect on the Company's
business, financial condition and results of operations.
As of December 31, 1998, the Company's other principal sources of liquidity
included cash of $139,000, amounts due from factor of $20.6 million and net
accounts receivable of $347,000. The Company had working capital of $36.3
million and long-term debt of $6.2 million as of December 31, 1998.
For 1998, operating activities provided cash of $2.5 million primarily as a
result of net income of $11.6 million and a decrease in amounts due from factor
of $2.8 million, offset in part by a decrease in accounts payable and accrued
expenses of $3.6 million, and an increase in inventory of $7.3 million. Net cash
used in financing activities during the same period was $2.4 million consisting
primarily of payments of $21.1 million under the Company's credit line and
payments to shareholders of $3.1 million offset in part by net the proceeds of
the Company's IPO.
Historically, the Company's business has not required significant capital
expenditures. The Company's capital expenditures for 1998 and 1997, were
$321,000 and $79,000, respectively. The Company expects to incur capital
expenditures in 1999 totaling $1.0 million for the purchase of new computers,
software and telecommunications equipment. The Company believes that cash flow
expected to be generated from operations, together with borrowings under its
existing credit line, as amended, will be adequate to satisfy current and
planned operations for at least the next 12 months.
17
<PAGE>
BACKLOG
The Company's customers order specific quantities of goods on a fixed-price
basis three to nine months in advance of a selling season. Such customer orders
are placed in backlog upon their receipt and acceptance by the Company. Customer
orders are generally cancelable on notice to the Company without penalty.
Although the Company has not had significant cancellations in the past, no
assurance can be given that it will not experience a significant level of
cancellations in the future or that its backlog at any point in time will be
converted to sales. Many of the Company's orders are received significantly in
advance of scheduled delivery periods. Consequently, the Company had backlog of
$123.5 million at December 31, 1998, all of which it expects to ship over the
next three to nine months. However, in recent months subsequent to the year
ended December 31, 1998, the Company has experienced a significant increase in
orders involving a rapid turnaround from the date the order is placed to the
shipment date.
VARIABILITY OF RESULTS; SEASONALITY; CYCLICALITY
Sales of children's apparel are seasonal. Consequently, the Company's
operating results have varied substantially from quarter to quarter, and the
Company expects that they will continue to do so. Generally, the Company has
experienced significantly higher net sales in the first and third quarters as
compared to the second and fourth quarters, although this may change from time
to time. The seasonality of the Company's business also affects borrowings under
the Company's lines of credit and its level of backlog, which fluctuate in
response to demand for the Company's products. Therefore, the results of any
interim period are not necessarily indicative of the results that may be
achieved for an entire year. In addition, the apparel industry is a cyclical
industry heavily dependent upon the overall level of consumer spending, with
purchases of apparel and related goods tending to decline during recessionary
periods when disposable income is low. A difficult retail environment could
result in downward price pressure which could adversely impact the Company's
gross profit margins.
PRO FORMA ADJUSTMENTS FOR INCOME TAXES
The Company has operated as an S Corporation for federal and New York state
income tax purposes since 1988 up and until the termination of the Company's S
Corporation status on April 1, 1998, immediately prior to the effectiveness of
the Company's IPO. As a result, for such tax periods, the Company's earnings
were taxed directly to the Company's shareholders. The pro forma adjustments for
income taxes reflected in Item 6 of this Form 10-K under the caption "Selected
Consolidated Financial Data" and in the accompanying Financial Statements were
calculated as if the Company were subject to tax under the tax laws in effect
for the respective periods using the criteria established under Statement of
Financial Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes."
The effective tax rate for the years ended December 31, 1998, 1997 and 1996 was
28.3%, 10.1% and 4.8% respectively. The change in the effective tax rate is the
result of payments made in connection with a settlement of an Internal Revenue
Service examination in 1996, and the utilization of State net operating loss
carryforward claims in 1997 and 1996.
18
<PAGE>
YEAR 2000 COMPLIANCE
General
The Company believes that advanced information processing is essential to
maintaining its competitive position. The Company participates in the electronic
data interchange program maintained by many of its larger customers, including
JC Penney, Kids R Us, Sears, Target and WalMart. This program allows the Company
to receive customer orders, provide advanced shipping notices, monitor store
inventory and track orders on-line from the time such orders are placed through
delivery.
Year 2000 Compliance
In 1998, the Company established an oversight committee to review all of
the Company's computer systems and programs, as well as the computer systems of
the third parties upon whose data or functionality the Company relies in any
material respect, and to assess their ability to process transactions in the
Year 2000 and beyond. The Company, through such oversight committee, currently
is upgrading its management information systems, which it expects to complete
during the second quarter of 1999, to ensure proper processing of transactions
relating to Year 2000 and beyond. The Company continues to evaluate appropriate
courses of corrective actions, including replacement of certain systems.
Although the Company does not expect the costs associated with ensuring Year
2000 compliance to have a material affect on its financial position or results
of operations, if the computer systems used by the Company, or any of its
suppliers or vendors fail or experience significant difficulties related to the
Year 2000, the Company could experience delays in manufacturing, delays in
shipping, an inability to monitor customer orders or to manage inventory, or may
experience related risks that could materially adversely affect the Company's
financial position or its results of operations. The Company has identified and
been in contact with its major customers, its bank and its factor. The reply
from each such entity indicates that each is, or will be, Year 2000 compliant.
The Company has incurred approximately $100,000 of expenses for Year 2000
remediation costs in 1998 and estimates future additional expenditures for Year
2000 remediation of approximately $100,000. All costs associated with Year 2000
compliance are being funded with cash flow generated from operations and are
being expensed as incurred. The Company has not developed a contingency plan
with respect to Year 2000 issues should they arise.
EUROPEAN MONETARY UNION
On January 1, 1999, eleven of the fifteen member countries of the European
Union set fixed conversion rates between their existing legacy currencies and
the euro. As such, these participating countries have agreed to adopt the euro
as their common legal currency. The eleven participating countries will issue
sovereign debt exclusively in euro and will redenominate outstanding sovereign
debt. The legacy currencies will continue to be used as legal tender through
January 1, 2002, at which point the legacy currencies will be canceled and euro
bills and coins will be used for cash transactions in the participating
countries.
19
<PAGE>
The Company does not denominate its agreements or transactions with foreign
entities in foreign currencies. The Company currently does not believe that the
euro conversion will have a material impact on the Company's financial condition
or results of operations.
EFFECT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133 ("SFAS No. 133"), "Accounting for Derivative Instruments and Hedging
Activities," which is effective for the Company's fiscal year ending December
31, 2000. SFAS No. 133 will require the Company to recognize all derivatives on
the balance sheet at fair value. Adoption of SFAS No. 133 is not expected to
have a material effect on the Company's financial statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK.
INTEREST RATE EXPOSURE
The Company is subject to market risk from exposure to changes in interest
rates relating primarily to the Company's short-term debt obligations. The
Company primarily enters into such short-term debt obligations to support
general corporate purposes, including capital expenditures and working capital
needs. All of the Company's debt is short-term with variable rates. To manage
its exposure to changes in interest rates, the Company's policy is to manage
such interest rate exposure through the use of short-term borrowings, which are
negotiated with their lenders on an annual basis. The Company does not expect
changes in interest rates to have a material adverse effect on income or cash
flows in fiscal 1999, although there can be no assurance that interest rates
will not significantly change.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The financial statements required to be filed pursuant to this Item 8 are
appended to this Annual Report on Form 10-K. A list of the financial statements
filed herewith is found at "Item 14. Exhibits, Financial Statement Schedules,
and Reports on Form 8-K."
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
20
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY.
The information relating to the Company's directors, nominees for election
as directors and executive officers under the headings "Election of Directors"
and "Executive Officers" in the Company's definitive proxy statement for the
1999 Annual Meeting of Stockholders is incorporated herein by reference to such
proxy statement.
ITEM 11. EXECUTIVE COMPENSATION.
The discussion under the heading "Executive Compensation" in the Company's
definitive proxy statement for the 1999 Annual Meeting of Stockholders is
incorporated herein by reference to such proxy statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The discussion under the heading "Security Ownership of Certain Beneficial
Owners and Management" in the Company's definitive proxy statement for the 1999
Annual Meeting of Stockholders is incorporated herein by reference to such proxy
statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The discussion under the heading "Certain Relationships and Related
Transactions" in the Company's definitive proxy statement for the 1999 Annual
Meeting of Stockholders is incorporated herein by reference to such proxy
statement.
21
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) (1) Financial Statements.
Reference is made to the Index to Financial Statements and Schedules
on Page F-1.
(2) Financial Statement Schedules.
Reference is made to the Index to Financial Statements and Schedules
on Page F-1.
(3) Exhibits.
Reference is made to the Index to Exhibits on Page 25.
(b) Reports on Form 8-K.
No reports on Form 8-K were filed during the quarter ended December
31, 1998.
22
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized this 30th day of March,
1999.
Happy Kids Inc.
By: /s/ Jack M. Benun
--------------------------------
Jack M. Benun
President and Chief Executive Officer
23
<PAGE>
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
- --------------------------------- -------------------------- -----------------
/s/ Jack M. Benun President, Chief Executive March 30, 1999
- ------------------------------
Jack M. Benun Officer and Director
(Principal Executive
Officer)
/s/ Stuart Bender Chief Financial Officer March 30, 1999
- ------------------------------
Stuart Bender and Treasurer (Principal
Financial and Accounting
Officer)
/s/ Mark J. Benun Executive Vice President, March 30, 1999
- ------------------------------
Mark J. Benun Secretary and Director
/s/ Isaac Levy Senior Vice President and March 30, 1999
- ------------------------------
Isaac Levy Director
/s/ Marvin Azrak Director March 30, 1999
- ------------------------------
Marvin Azrak
Director
- ------------------------------
Stephen I. Kahn
24
<PAGE>
EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION OF EXHIBIT
----------- ----------------------
3.1 Restated Certificate of Incorporation. (Incorporated
by reference to Exhibit 3.1 to the Company's
Registration Statement on Form S-1 (File Number
333-44267) which became effective April 2, 1998.)
3.2 Amended and Restated Bylaws. (Incorporated by
reference to Exhibit 3.2 to the Company's Registration
Statement on Form S-1 (File Number 333-44267) which
became effective April 2, 1998.)
4.1 Voting Agreement, dated January 1, 1998, by and
between Jack Benun and Mark Benun. (Incorporated by
reference to Exhibit 4.1 to the Company's Registration
Statement on Form S-1 (File Number 333-44267) which
became effective April 2, 1998.)
4.2 Shareholder Agreement, dated January 1, 1998, by and
among Jack Benun, Mark Benun and Isaac Levy.
(Incorporated by reference to Exhibit 4.2 to the
Company's Registration Statement on Form S-1 (File
Number 333-44267) which became effective April 2,
1998.)
10.1* 1997 Stock Option Plan. (Incorporated by reference to
Exhibit 10.1 to the Company's Registration Statement
on Form S-1 (File Number 333-44267) which became
effective April 2, 1998.)
10.2 Form of Indemnification Agreement executed by each of
the Company's directors and officers. (Incorporated
by reference to Exhibit 10.2 to the Company's
Registration Statement on Form S-1 (File Number
333-44267) which became effective April 2, 1998.)
10.3 Lease Agreement, by and between J&B Corp. and SZS 33
Associates L.P., as amended. (Incorporated by
reference to Exhibit 10.3 to the Company's
Registration Statement on Form S-1 (File Number
333-44267) which became effective April 2, 1998.)
10.4 Lease Agreement, by and between Hawk Industries, Inc.
and Triangle Fidelco Industrial Center, as amended.
(Incorporated by reference to Exhibit 10.4 to the
Company's Registration Statement on Form S-1 (File
Number 333-44267) which became effective April 2,
1998.)
10.5 Financing Agreement with the CIT Group/Commercial
Services, Inc., as Agent for itself and certain other
lenders, as amended. (Incorporated by reference to
Exhibit 10.5 to the Company's Registration Statement
on Form S-1 (File Number 333-44267) which became
effective April 2, 1998.)
25
<PAGE>
EXHIBIT NO. DESCRIPTION OF EXHIBIT
----------- ----------------------
10.6 Notification Factoring Agreement. (Incorporated by
reference to Exhibit 10.6 to the Company's
Registration Statement on Form S-1 (File Number
333-44267) which became effective April 2, 1998.)
10.7* Employment Agreement, by and between the Company and
Jack Benun. (Incorporated by reference to Exhibit 10.7
to the Company's Registration Statement on Form S-1
(File Number 333-44267) which became effective April
2, 1998.)
10.8* Employment Agreement, by and between the Company and
Mark Benun. (Incorporated by reference to Exhibit 10.8
to the Company's Registration Statement on Form S-1
(File Number 333-44267) which became effective April
2, 1998.)
10.9* Employment Agreement, by and between the Company and
Isaac Levy. (Incorporated by reference to Exhibit 10.9
to the Company's Registration Statement on Form S-1
(File Number 333-44267) which became effective April
2, 1998.)
10.10* Employment Agreement, by and between the Company and
Stuart Bender. (Incorporated by reference to Exhibit
10.10 to the Company's Registration Statement on Form
S-1 (File Number 333-44267) which became effective
April 2, 1998.)
10.11 Model Form of Confidentiality/Non Solicitation
Agreement. (Incorporated by reference to Exhibit 10.11
to the Company's Registration Statement on Form S-1
(File Number 333-44267) which became effective April
2, 1998.)
10.12 Securities Purchase Agreement, dated as of January 1,
1998, by and among, the Company and Jack M. Benun and
Mark J. Benun. (Incorporated by reference to Exhibit
10.12 to the Company's Registration Statement on Form
S-1 (File Number 333-44267) which became effective
April 2, 1998.)
10.13** License Agreement by and between the Company and MTV
Networks. (Incorporated by reference to Exhibit 10.13
to the Company's Registration Statement on Form S-1
(File Number 333-44267) which became effective April
2, 1998.)
26
<PAGE>
EXHIBIT NO. DESCRIPTION OF EXHIBIT
----------- ----------------------
10.14** License Agreement by and between the Company and
B.U.M. Equipment. (Incorporated by reference to
Exhibit 10.14 to the Company's Registration Statement
on Form S-1 (File Number 333-44267) which became
effective April 2, 1998.)
10.15** License Agreement by and between the Company and Ocean
Pacific Apparel Corp. (Incorporated by reference to
Exhibit 10.15 to the Company's Registration Statement
on Form S-1 (File Number 333-44267) which became
effective April 2, 1998.)
10.16 Amendment No. 5 to the Company's Financing Agreement,
dated March 25, 1998, with the CIT Group/Commercial
Services, Inc., as agent for itself and certain other
lenders, as previously amended. (Incorporated by
reference to Exhibit 10.1 to the Company's Form 10-Q
for the quarter ended March 31, 1998.)
10.17*+ Change in Control Severance Pay Agreement, by and
between the Company and Stuart Bender.
21 Subsidiaries of the Registrant. (Incorporated by
reference to Exhibit 21 to the Company's Registration
Statement on Form S-1 (File Number 333-44267) which
became effective April 2, 1998.)
27+ Financial Data Schedule for the years ended December
31, 1998 and 1997.
-----------------------
* A management contract or compensatory plan or arrangement required
to be filed as an exhibit pursuant to Item 14(c) of Form 10-K.
** Confidential treatment has been requested for a portion of this
Exhibit.
+ Filed herewith. All other exhibits incorporated by reference.
(b) Financial Statement Schedules
27
<PAGE>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Report of Independent Certified Public Accountants................. F-2
Consolidated Balance Sheets
as of December 31, 1997 and 1998.................................. F-3
Consolidated Statements of Operations for the
years ended December 31, 1996, 1997 and 1998....................... F-4
Consolidated Statements of Stockholders'
Equity for the years ended December 31, 1996, 1997 and 1998........ F-5
Consolidated Statements of Cash Flows for the years
ended December 1996, 1997 and 1998................................. F-6
Notes to Consolidated Financial Statements......................... F-7
Schedule II - Valuation and Qualifying Accounts.................... F-25
F-1
<PAGE>
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Board of Directors
HAPPY KIDS INC.
We have audited the accompanying consolidated balance sheets of Happy Kids Inc.
and Subsidiaries as of December 31, 1997 and 1998, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of the
three years in the period ended December 31, 1998. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Happy Kids Inc.
and Subsidiaries as of December 31, 1997 and 1998, and the consolidated results
of their operations and their consolidated cash flows for each of the three
years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles.
We have also audited Schedule II of Happy Kids Inc. and Subsidiaries as of and
for the three years ended December 31, 1998. In our opinion, this schedule
presents fairly, in all material respects, the information required to be set
forth therein.
GRANT THORNTON LLP
New York, New York
February 5, 1999
F-2
<PAGE>
Happy Kids Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
December 31,
ASSETS 1997 1998
---- ----
CURRENT ASSETS:
Cash........................................... $ 374 $ 139
Due from factor................................ 24,232 20,640
Accounts receivable - trade (net of
allowance for doubtful accounts of $513
at December 31, 1997 and 1998)............... 316 347
Inventories.................................... 16,316 23,579
Due from stockholders.......................... 347 --
Prepaid royalties.............................. 147 762
Deferred income taxes.......................... 40 1,029
Other current assets........................... 952 1,496
------ ------
Total current assets........................ 42,724 47,992
FIXED ASSETS - NET................................ 1,476 1,459
OTHER ASSETS...................................... 752 1,001
------ ------
Total assets................................ $44,952 $50,452
====== ======
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Due to bank.................................... $24,863 $ 3,753
Current portion - capital lease obligations.... 49 27
Accounts payable............................... 9,468 6,017
Accrued liabilities............................ 1,925 1,900
------ ------
Total current liabilities................... 36,305 11,697
DEFERRED RENT PAYABLE............................. 584 505
CAPITAL LEASE OBLIGATIONS......................... 19 --
DUE TO STOCKHOLDERS............................... 1,400 5,719
COMMITMENTS
STOCKHOLDERS' EQUITY:
Preferred stock - 5,000 shares authorized,
$.01 par value; no shares issued and
outstanding................................... -- --
Common stock - 30,000 shares authorized,
$.01 par value; 7,750 and 10,280 shares
issued and outstanding at December 31,
1997 and 1998, respectively................... 78 103
Additional paid-in capital...................... 1,119 23,263
Retained earnings............................... 5,447 9,165
------ ------
Total stockholders' equity.................. 6,644 32,531
------- ------
Total liabilities and stockholders' equity.. $44,952 $50,452
====== ======
The accompanying notes are an integral part of these statements.
F-3
<PAGE>
Happy Kids Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
Year ended December 31,
(in thousands, except per share data)
1996 1997 1998
---- ---- ----
Net sales.................................... $ 90,723 $106,673 $154,559
Cost of goods sold........................... 69,886 79,748 113,796
------ ------ -------
Gross profit............................ 20,837 26,925 40,763
Operating expenses........................... 15,370 18,457 22,449
------ ------ -------
Operating earnings...................... 5,467 8,468 18,314
Interest expense, net........................ 2,980 3,803 2,077
------ ------ -------
Income before income taxes.............. 2,487 4,665 16,237
Income taxes................................. 119 473 4,603
------ ------ -------
Net income.............................. $ 2,368 $ 4,192 $ 11,634
====== ====== =======
Basic income per share....................... $ 0.31 $ 0.54 $ 1.21
====== ====== =======
Diluted income per share..................... $ 0.31 $ 0.54 $ 1.21
====== ====== =======
Pro forma data (unaudited):
Historical income before income taxes...... $ 2,487 $ 4,665 $ 16,237
Income taxes............................... 990 1,961 6,657
------ ------ -------
Net income.............................. $ 1,497 $ 2,704 $ 9,580
====== ====== =======
Pro forma basic net income per share...... $ 0.19 $ 0.35 $ 1.00
====== ====== =======
Pro forma weighted average shares
outstanding - basic...................... 7,750 7,750 9,625
====== ====== =======
Pro forma diluted net income per share.... $ 0.19 $ 0.35 $ 0.99
====== ====== =======
Pro forma weighted average shares
outstanding - diluted..................... 7,750 7,750 9,637
====== ====== =======
The accompanying notes are an integral part of these statements.
F-4
<PAGE>
Happy Kids Inc. and Subsidiaries
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
Years ended December 31, 1996, 1997 and 1998
(in thousands)
Additional
Common stock paid-in Retained
-----------------
Shares Amount capital earnings
------ ------ ------- --------
Balance at January 1, 1996...... 7,750 $ 78 $ 1,041 $ 2,729
Waived payment of interest on
shareholder's note............. -- -- 78 --
Dividends....................... -- -- -- (721)
Net income...................... -- -- -- 2,368
------ ----- ------ ------
Balance at December 31, 1996.... 7,750 78 1,119 4,376
Dividends....................... -- -- -- (3,121)
Net income...................... -- -- -- 4,192
------ ----- ------ ------
Balance at December 31, 1997.... 7,750 78 1,119 5,447
Net proceeds from initial
public offering................ 2,530 25 22,144 --
Conversion of undistributed
shareholder equity to loan
payable........................ -- -- -- (7,550)
Dividends....................... -- -- -- (366)
Net income...................... -- -- -- 11,634
------ ----- ------ ------
Balance at December 31, 1998.... 10,280 $ 103 $23,263 $ 9,165
====== ===== ====== ======
The accompanying notes are an integral part of this statement.
F-5
<PAGE>
Happy Kids Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year ended December 31,
1996 1997 1998
------ ------ -----
Cash flows from operating activities
Net income................................. $ 2,368 $ 4,192 $ 11,634
Adjustments to reconcile net income to net
cash provided by (used in) operating
activities:
Depreciation and amortization........... 388 336 338
Provision for losses on accounts
receivable and other receivables...... 212 354 882
Deferred income taxes................... (8) 164 (912)
Noncash interest expense................ 78 -- --
Changes in operating assets and
liabilities:
Accounts receivable................... 10,521 741 (31)
Due from factor....................... (16,925) (7,307) 2,815
Inventories........................... 5,669 (6,829) (7,263)
Other current assets.................. (471) 815 (649)
Prepaid royalties..................... 218 42 (615)
Other assets.......................... (196) 13 (488)
Accounts payable and accrued
liabilities.......................... 919 5,083 (3,555)
Due from stockholders................. 308 469 347
------ ------ ------
Net cash provided by (used in)
operating activities.................. 3,081 (1,927) 2,503
------ ------ ------
Cash flows from investing activities:
Acquisition of fixed assets................ (378) (79) (321)
------ ------ ------
Cash flows from financing activities:
Net borrowings (payments) under line of
credit.................................... (1,608) 5,131 (21,110)
Payments on capital lease.................. (43) (56) (41)
Borrowings from (payments to) stockholders. 60 (160) (169)
Dividends paid............................. (721) (3,121) (366)
Payments on stockholders' notes payable.... -- -- (3,062)
Proceeds from initial public offering,
net....................................... -- (88) 22,331
------ ------ ------
Net cash (used in) provided by
financing activities.................. (2,312) 1,706 (2,417)
------ ------ ------
NET INCREASE (DECREASE) IN CASH......... 391 (300) (235)
Cash at beginning of year.................... 283 674 374
------ ------ ------
Cash at end of year.......................... $ 674 $ 374 $ 139
====== ====== =======
The accompanying notes are an integral part of these statements.
F-6
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE A - SUMMARY OF ACCOUNTING POLICIES
Happy Kids Inc. (the "Company") was incorporated in 1988 in New York under
the name O'Boy Inc. and changed its name to Happy Kids Inc. in December 1997.
Historically, the Company operated as separate business entities, with the
first of such entities commencing operations in 1979, all under the common
ownership of the stockholders of the Company. Immediately prior to the
effectiveness of the Initial Public Offering as described in Note K, all of
such separate entities became wholly-owned subsidiaries of the Company. The
Company issued 4,263 shares of common stock, to the principal stockholders,
in exchange for their ownership in these separate business entities. All
share and per share amounts have been restated to retroactively reflect the
reorganization.
The accompanying consolidated financial statements include the consolidated
accounts of the Company and its wholly-owned subsidiaries to reflect the
reorganization as stated above. All significant intercompany accounts and
transactions have been eliminated in consolidation.
The Company operates in one business segment - as a designer and marketer of
licensed and branded children's apparel. The Company's revenues are derived
from the sale of children's apparel to mass market retailers, mid-tier
distributors and department stores in the United States.
A summary of the significant accounting policies consistently applied in the
preparation of the accompanying consolidated financial statements follows:
1. Revenue Recognition
Sales are recognized when merchandise is shipped to customers.
2. Inventories
Inventories, consisting primarily of finished goods, are stated at the
lower of cost or market. One subsidiary determines cost by the last-in,
first-out ("LIFO") method which represented approximately $808 and $407 of
total inventory at December 31, 1997 and 1998, respectively. The other
subsidiaries determine cost by the first-in, first-out ("FIFO") method.
F-7
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE A (continued)
3. Depreciation and Amortization
The Company depreciates fixed assets over their estimated useful lives by
the straight-line method. Leasehold improvements are depreciated over
their expected useful life or the life of the respective leases, whichever
is shorter.
The following are the estimated lives of the Company's fixed assets:
Furniture and fixtures 5 years to 10 years
Equipment 5 years to 10 years
Leasehold improvements up to 10 years
4. Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and demand deposits.
Supplemental disclosures of cash flow information:
Year ended December 31,
----------------------------
1996 1997 1998
---- ---- ----
Cash paid during the year for
Interest...................... $2,711 $2,992 $1,764
Income taxes.................. 280 122 6,149
Noncash investing and financing activities:
For the year ended December 31, 1996, the Company acquired equipment
totaling approximately $49 under capital leases.
F-8
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE A (continued)
5. Income Taxes
Prior to the completion of the Initial Public Offering, the Company had
elected to be treated as an S Corporation for Federal income tax reporting
purposes. An S Corporation is generally treated like a partnership and is
exempt from Federal income taxes, with certain exceptions, and
shareholders report their pro rata share of corporate taxable income or
loss on their individual tax returns. A provision for state income taxes
was made for those states not recognizing the Company's S Corporation
status. The Company's S Corporation status terminated on the day prior to
the effectiveness of the Company's Initial Public Offering described in
Note K-3.
Subsequent to the termination of the Company's S Corporation status, the
Company used the liability method for both Federal and state income tax
purposes. The effect of such change was reflected in net income for the
second quarter of 1998 when such termination occurred and resulted in an
increase in deferred tax assets and net earnings of approximately $1,024.
The pro forma provision for income taxes represents the income tax
provision that would have been reported had the Company been subject to
Federal and additional state and local income taxes as a C Corporation for
all periods presented.
Deferred income taxes are determined based on the difference between the
tax basis of an asset or liability and its reported amount in the
financial statements using enacted tax rates for the year in which the
differences are expected to reverse.
The principal types of differences between assets and liabilities for
financial statement and tax return purposes giving rise to deferred income
taxes are accrued expenses, accumulated depreciation, certain costs
capitalized to inventory and allowance for doubtful accounts. A deferred
tax asset has been recorded for these differences.
F-9
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE A (continued)
6. Use of Estimates
In preparing financial statements in conformity with generally accepted
accounting principles, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and revenues and expenses during the reporting
period. Actual results could differ from those estimates.
The Company estimates an allowance for doubtful accounts based on the
creditworthiness of their customers as well as general economic
conditions. Consequently, an adverse change in those conditions could
affect the Company's estimate. See Note I.
7. Fair Value of Financial Instruments
Due to the short-term nature of the bank loans, the fair value of the
Company's due to bank approximates carrying value. Furthermore, the
carrying value of all other financial instruments potentially subject to
valuation risk (principally consisting of cash, accounts receivable, due
from factor and accounts payable) also approximates fair value.
8. Future Effect of Recently Issued Accounting Pronouncements
In June 1998, the FASB issued Statement of Financial Accounting
Standards No. 133 ("SFAS No. 133"), "Accounting for Derivative
Instruments and Hedging Activities," which is effective for the
Company's fiscal year ending December 31, 2000. SFAS No. 133 will
require the Company to recognize all derivatives on the balance sheet
at fair value. Adoption of SFAS No. 133 is not expected to have a
material effect on the Company's financial statements.
9. Earnings Per Share
Basic earnings per share is based on the weighted average number of common
shares outstanding without consideration of common stock equivalents.
Diluted earnings per share are based on the weighted average number of
common and common equivalent shares outstanding.
F-10
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE A (continued)
A reconciliation between basic and diluted earnings per share is as
follows:
December 31,
---------------------------------
1996 1997 1998
---- ---- ----
Net income...................... $ 2,368 $ 4,192 $11,634
====== ====== ======
Basic common shares............. 7,750 7,750 9,625
====== ====== ======
Basic earnings per share........ $ 0.31 $ 0.54 $ 1.21
====== ====== ======
Basic common shares............. 7,750 7,750 9,625
Diluted common shares........... -- -- 12
------ ------ ------
Total diluted shares............ 7,750 7,750 9,637
====== ====== ======
Diluted earnings per share...... $ 0.31 $ 0.54 $ 1.21
====== ====== ======
10.Reclassification
Certain prior year amounts have been reclassified to conform to the 1998
presentation.
F-11
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE B - INVENTORIES
Inventories consist of the following finished goods:
December 31,
----------------------------
1997 1998
---- ----
Warehouse............................... $ 8,716 $16,531
In-transit and overseas................. 8,010 5,921
Raw materials........................... -- 1,356
LIFO valuation allowance................ (410) (229)
------ ------
$16,316 $23,579
====== ======
For the years ended December 31, 1996, 1997 and 1998, the liquidation of LIFO
inventories decreased cost of sales and, therefore, increased income before
taxes by $521, $390 and $181, respectively.
NOTE C - FACTORED ACCOUNTS RECEIVABLE - WITHOUT
RECOURSE AS TO CREDIT RISK
The Company has an agreement with a commercial finance company which provides
for the factoring of trade accounts receivable. The factoring charge amounts
to 0.55% of the receivables assigned. Factor charges for the years ended
December 31, 1996, 1997 and 1998 were approximately $643, $735 and $966,
respectively. The commercial finance company also guarantees the Company's
letters of credit and issues letters of guarantee to company suppliers. The
commercial finance company has a first lien on all of the Company's tangible
assets as collateral for all of its obligations under the financing
agreement. Advances and loans under the agreement bear interest at the prime
rate.
The aggregate amounts of such guarantees and advances are limited by formula
based upon the uncollected balance of 85% of eligible factored receivables,
and 50% of eligible inventory collateral, plus 50% of letters of credit
outstanding, and 25% of open letters of credit and any overadvance amount
permitted by the lender. At December 31, 1997 and 1998, the maximum amount of
guarantees and advances permitted by such formula was approximately $34,723
and $35,472, respectively.
F-12
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE C (continued)
Accounts receivable are factored without recourse as to credit risk but with
recourse for any claims by the customer for adjustments in the normal course
of business relating to price errors, shortages, etc. The uncollected balance
of receivables held by the commercial finance company amounted to
approximately $24,232 and $20,640 at December 31, 1997 and 1998,
respectively.
NOTE D - FIXED ASSETS
Fixed assets are recorded at cost and consist of the following:
December 31,
------------------
1997 1998
---- ----
Furniture and fixtures...................... $ 893 $ 945
Equipment................................... 657 726
Leasehold improvements...................... 1,158 1,358
----- -----
2,708 3,029
Less accumulated depreciation and
amortization............................. 1,232 1,570
----- -----
$1,476 $1,459
===== =====
NOTE E - DUE TO BANK
The Company has a financing agreement with several banks that expires on
March 31, 1999, subject to annual renewals. The agreement provides for
advances and letter of credit accommodations ranging between $42.0 million
and $49.0 million subject to borrowing base formulas. The maximum amount of
revolving credit advances outstanding at any time cannot exceed $35.0 million
from January 1, 1998 to April 30, 1998 and $30.0 million thereafter, and the
maximum amount of letters of credit outstanding at any time may not exceed
$35.0 million. The borrowings under this line of credit bear interest at the
prime rate. Borrowings are collateralized by substantially all of the assets
of the Company. At December 31, 1997 and 1998, the Company has borrowed
$24,863 and $3,753, respectively, under this line. The agreement provides for
various restrictive financial covenants, including the requirement to
maintain a minimum tangible net worth level. The agreement prohibits the
payment of dividends.
F-13
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE F - TRANSACTIONS WITH STOCKHOLDERS
Notes payable to stockholder consist of:
December 31,
----------------------
1997 1998
------ ------
5.7% due to stockholders.................. -- $5,719
7% due to stockholder..................... $1,400 --
----- -----
$1,400 $5,719
===== =====
In connection with the termination of the Company's S Corporation status, the
Company agreed to distribute an aggregate $7,550 to the Company's pre-Initial
Public Offering shareholders, such amounts representing the Company's total
undistributed equity resulting from the S Corporation or limited liability
corporation ("LLC") status of the Company and its related entities, prior to
the Reorganization, of which $2,000 was paid from the proceeds of the Initial
Public Offering. The balance is due pursuant to four-year, 5.7% notes payable
to such shareholders. Such notes provide for the timely distribution of
amounts necessary to pay the remaining personal income taxes of such
shareholders or members due on amounts earned by such S Corporations or LLCs
for the period January 1, 1998 through the termination of S Corporation or
LLC status of approximately $314. In addition, existing amounts due to
shareholders of $1,400 as of April 2, 1998 were converted to the 5.7% note
payable to such stockholder and are subject to the same terms as the above
promissory notes.
Interest expense on these notes for the years ended December 31, 1996, 1997
and 1998 was approximately $107, $98 and $301, respectively. Interest
totaling $78 for the year ended December 31, 1996, was waived and recorded as
additional paid-in capital.
The three principal stockholders have entered into a stockholders' agreement
dated January 1, 1998. Such agreement provides tag-along rights to each of
the parties thereto in the event that any of the other parties elect to sell
their common stock under certain circumstances. In addition, each party is
granted a right of first refusal to purchase any shares of common stock
offered for sale by any other party to the agreement.
For the years ended December 31, 1996, 1997 and 1998, the Company contributed
$127, $180 and $165, respectively, to a charitable foundation managed by an
executive of the Company.
F-14
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE G - COMMITMENTS AND CONTINGENCIES
The Company leases showroom, office and warehouse facilities through May 31,
2006 at the following minimum annual rentals:
Year ending December 31, Amount
------------------------ ------
1999 $1,281
2000 1,043
2001 947
2002 947
2003 947
Thereafter 2,292
-----
$7,457
=====
Rent expense for the years ended December 31, 1996, 1997 and 1998 was
approximately $1,138, $1,126 and $1,187, respectively.
At December 31, 1998, the Company is contingently liable under open letters
of credit in the amount of approximately $13,655.
The Company has entered into royalty agreements that provide for royalty
payments from 6% to 12% of net sales of licensed products. The Company
incurred royalty expense (included in cost of goods sold) of approximately
$3,685, $4,113 and $7,886 for the years ended December 31, 1996, 1997 and
1998, respectively. Based on minimum sales requirements, future minimum
royalty payments required under these agreements are:
Year ending December 31, Amount
------------------------ ------
1999 $ 3,196
2000 3,628
2001 3,055
2002 418
2003 273
------
$10,570
======
F-15
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE G (continued)
Executive Compensation
Effective January 1, 1998, the Company entered into employment agreements
with its executive officers for initial terms expiring in two years at
initial aggregate annual base salaries of $1,250.
In addition, the Company has a severance agreement with an officer of the
Company, which provides that, in the event of a change of control of the
Company, the executive would have the right to receive payments at a rate of
three times the individual's annual regular compensation upon termination of
employment within one year.
Year 2000
The Year 2000 issue relates to limitations in computer systems and
applications that may prevent proper recognition of the Year 2000. The
potential effect of the Year 2000 issue on the Company and its business
partners will not be fully determinable until the Year 2000 and thereafter.
If Year 2000 modifications are not properly completed either by the Company
or entities with which the Company conducts business, the Company's revenues
and financial condition could be adversely impacted.
NOTE H - EMPLOYEE BENEFIT PLAN
The Company has established a 401(k) Profit Sharing Plan covering
substantially all eligible employees. The plan allows employees to defer a
percentage of their annual earnings subject to limitation of Section 401(m)
of the Internal Revenue Code.
The plan provides that the Company can make discretionary contributions.
These contributions are allocated to the participant based on the
participant's compensation in proportion to the compensation of all
participants. The Company's contribution to the plan for the years ended
December 31, 1996, 1997 and 1998 was approximately $31, $34 and $45,
respectively.
F-16
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE I - CONCENTRATIONS
During the years ended December 31, 1996, 1997 and 1998, approximately 40%,
41% and 43%, respectively, of total purchases of the Company were made from
companies located in one overseas country. In addition, for the years ended
December 31, 1996, 1997 and 1998, 37%, 31% and 29%, respectively, of total
purchases of the Company were made from companies located in a second
overseas country. In addition, the Company relied on two manufacturers for
18%, 11% and 7%, and 11%, 13% and 18% of the Company's production for the
years ended December 31, 1996, 1997 and 1998, respectively. The Company's
import operations are subject to constraints imposed by bilateral textile
agreements between the United States and a number of foreign countries. These
agreements impose quotas on the amount and types of goods which can be
imported into the United States from these countries. The Company's
operations may be adversely affected by political instability, resulting in
the disruption of trade from foreign countries in which the Company's
contractors and suppliers are located, the imposition of additional
regulations relating to imports or duties, taxes, quotas and other charges on
imports. The Company is unable to predict whether any additional regulations,
duties, taxes, quotas or other charges may be imposed on the importation of
its products. The assessment of any of these items could result in increases
in the cost of such imports and affect sales and profitability. In addition,
the failure of manufacturers to ship some or all of the Company's orders on
time could impact the Company's ability to deliver products to its customers.
The Company does not have long-term contracts with any of its contract
manufacturers. The Company believes that alternate sources of manufacturing
are available if the need were to arise, although any substantial delay in
locating, or inability to locate, acceptable alternate sources of
manufacturing could have a material adverse effect on the Company's business,
financial condition and results of operations.
The Company's sales are made principally to department stores, mid-tier
distributors and mass market retailers of children's apparel. Sales to
customers that represent more than 10% of the Company's net sales are as
follows:
Year ended December 30, 1998 22%, 14% and 11%
Year ended December 30, 1997 17%, 14% and 11%
Year ended December 30, 1996 22% and 13%
F-17
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE J - INCOME TAXES
Prior to the completion of the Initial Public Offering, the Company had
elected to be treated as an S Corporation for Federal income tax reporting
purposes. An S Corporation is generally treated like a partnership and is
exempt from Federal income taxes, with certain exceptions, and shareholders
report their pro rata share of corporate taxable income or loss on their
individual tax returns. A provision for state income taxes was made for those
states not recognizing the Company's S Corporation status. The Company's S
Corporation status terminated on the day prior to the effectiveness of the
Company's Initial Public Offering described in Note K-3.
The components of income tax expense (benefit) are summarized as follows:
Year ended December 31,
----------------------------------
1996 1997 1998
---- ---- ----
Current
Federal........................ $ 17 $347 $4,304
State and city................. 109 (38) 1,211
--- --- -----
126 309 5,515
Deferred......................... (7) 164 (912)
--- --- -----
$119 $473 $4,603
=== === =====
Income tax expense for the years ended December 31, 1996 and 1997
and for the period ended April 2, 1998 does not include income taxes
for those subsidiaries which are S Corporations or LLCs. Reference
is made to Note A-5.
F-18
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE J (continued)
The tax effect of temporary differences which gave rise to deferred tax
assets and liabilities are as follows:
December 31,
-----------------------
1997 1998
------ ------
Provision for losses on accounts receivable
and other receivables..................... $ 33 $ 409
Accrued expenses............................. 280 200
Depreciation................................. (1) (2)
Costs capitalized to inventory............... 16 636
Other........................................ -- --
--- -----
Net deferred tax asset....................... $328 $1,243
=== =====
Current...................................... $ 40 $1,029
Long-term.................................... 288 214
During the year ended December 31, 1996, the Internal Revenue Service ("IRS")
completed an examination of the tax returns of Happy Kids, Ltd. for the years
ended December 31, 1991, 1992 and 1993. As a result of the examination, Happy
Kids, Ltd. recorded an additional $235 in Federal and state income taxes and
$55 in penalties and interest.
At December 31, 1998, the IRS has cleared the tax returns of Happy Kids, Ltd.
through December 31, 1996.
NOTE K - STOCKHOLDERS' EQUITY
1. Stock Option Plan
The Company's 1997 Stock Option Plan (the "Plan") was adopted by the Board
of Directors and approved by the shareholders of the Company on December
31, 1997. A total of 800,000 shares of common stock are reserved for
issuance upon exercise of options and/or stock purchase rights to be
granted under the Plan. Those eligible to receive stock option grants or
stock purchase rights under the Plan include employees, nonemployee
directors and consultants.
F-19
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE K (continued)
Subject to the provisions of the Plan, the administrator of the Plan has
the discretion to determine the optionees and/or grantees, the type of
options to be granted (incentive stock options ("ISOs") or nonqualified
stock options ("NQSOs")), the vesting provisions, the terms of the option
grants and such other related provisions as are consistent with the Plan.
The exercise price of an ISO may not be less than the fair market value
per share of the common stock on the date of grant or, in the case of an
optionee who beneficially owns 10% or more of the outstanding capital
stock of the Company, not less than 110% of the fair market value per
share on the date of grant. The exercise price of a NQSO may not be less
than 85% of the fair market value per share of the common stock on the
date of grant, or, in the case of any optionee who beneficially owns 10%
or more of the outstanding capital stock of the Company, not less than
110% of the fair market value per share on the date of grant. The purchase
price of shares issued pursuant to stock purchase rights may not be less
than 50% of the fair market value of such shares as of the offer date of
such rights.
The options terminate not more than ten years from the date of grant,
subject to earlier termination on the optionee's death, disability or
termination of employment with the Company, but provide that the term of
any options granted to a holder of more than 10% of the outstanding shares
of common stock may be no longer than five years. The Plan terminates on
December 31, 2007.
The weighted average fair value at date of grant for options granted
during 1998 was $4.47 per option. The fair value of each option at date of
grant was estimated using the Black-Scholes option pricing model with the
following weighted-average assumptions for grants in 1998:
Expected stock price volatility 35%
Expected lives of options 7 years
Risk-free interest rate 5.7%
Expected dividend yield 0%
F-20
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE K (continued)
Information regarding these option plans for 1998 is as follows:
<TABLE>
<CAPTION>
Incentive options Nonqualified options
----------------- --------------------
Weighted- Weighted-
average average
exercise exercise
Shares price Shares price
------ ----- ------ -----
<S> <C> <C> <C> <C>
Options outstanding at
beginning of year
Exercised........................ -- -- -- --
Granted.......................... 100 $10 80 $10
Canceled or forfeited............ -- -- -- --
--- --- --- ---
Options outstanding at end of year.. 100 $10 80 $10
=== === === ===
Exercisable......................... -- --
=== ===
</TABLE>
The following table summarizes information about stock options outstanding as
of December 31, 1998:
<TABLE>
<CAPTION>
Number Weighted- Number
outstanding average Weighted exercisable Weighted-
as of remaining average as of average
Exercise December 31, contractual exercise December 31, exercise
price 1998 life price 1998 price
------- ------------ ----------- -------- ------------ ---------
<S> <C> <C> <C> <C> <C> <C>
$10 180 9.21 years $10 -- $10
</TABLE>
F-21
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE K (continued)
2. Stock Split
As of December 31, 1997, the Company effected a 34,875-for-1 stock split
of the Company's outstanding common stock. A total of 7,750 shares of
common stock will be issued and outstanding after the split. All share and
per share amounts have been restated to retroactively reflect the stock
splits.
3. Initial Public Offering
On April 2, 1998, the Company consummated its Initial Public Offering of
2,200 shares of its common stock at a price of $10.00 per share, all of
which shares were issued and sold by the Company. On April 23, 1998, the
Company consummated the exercise of the underwriters' overallotment option
granted by the Company to the underwriters in connection with the Initial
Public Offering. As a result, the Company issued and sold an additional
330 shares of the Company's common stock at the Initial Public Offering
price of $10.00 per share. The net proceeds to the Company from such sales
were approximately $22,331.
Of the total net proceeds received by the Company upon the consummation of
its Initial Public Offering and the exercise of the over allotment option,
$2,000 was distributed to certain shareholders of the Company in
connection with the payment of a portion of the S Corporation distribution
made by the Company in connection with the Reorganization (Note F) and the
remaining amount was utilized to pay down a portion of the outstanding
balance under the Company's bank credit facility.
F-22
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE L - PRO FORMA INFORMATION (UNAUDITED)
1. Pro Forma Results of Operations and Pro Forma Income Taxes
Pro forma adjustments in the statements of operations for the years ended
December 31, 1996, 1997 and 1998 reflect a provision for income taxes
based upon pro forma pretax income as if the Company had been subject to
Federal and additional state and local income taxes for the full periods.
As disclosed in Note A-5, the Company elected for certain of its
affiliates to be taxed as an S Corporation or to be treated as a
partnership pursuant to the Internal Revenue Code. In connection with the
Offering, the Company terminated its S Corporation and Partnership
elections and became subject to Federal and additional state and local
income taxes. The pro forma provision for income taxes represents the
income tax provisions that would have been reported had the Company been
subject to Federal and additional state and local income taxes for the
years ended December 31, 1996, 1997 and for the period ended April 2,
1998. The effective pro forma tax rate of the Company differs from the
Federal rate primarily due to the effects of state income taxes.
The pro forma provision for income taxes, after giving effect to the
Federal statutory rate and an approximate state tax provision after
reflecting the Federal tax benefit, consists of the following:
Year ended December 31,
-----------------------------------
1996 1997 1998
---- ---- ----
Federal...................... $661 $1,481 $5,187
State........................ 329 480 1,470
--- ----- -----
$990 $1,961 $6,657
=== ===== =====
F-23
<PAGE>
Happy Kids Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 1996, 1997 and 1998
(in thousands, except per share data)
NOTE L (continued)
The differences between pro forma tax expense shown in the statements of
operations and the pro forma computed income tax expense based on the
Federal statutory corporate rate are as follows:
Year ended December 31,
----------------------------
1996 1997 1998
---- ---- ----
Computed income taxes based on Federal
statutory rate of 34% in 1996 and
1997, and 35% in 1998................ $ 845 $1,586 $5,683
State income taxes, net of Federal
benefit............................... 217 317 956
Benefit of utilization of net
operating losses......................... (160) -- --
Interest waived on debt.................. 33 -- --
Officer's life insurance................. 40 32 --
Other.................................... 15 26 18
---- ----- -----
$ 990 $1,961 $6,657
==== ===== =====
2. Pro Forma Net Income and Net Income Per Common Share
Pro forma net income represents the historical amounts after the pro forma
adjustments discussed above.
Pro forma net income per share is based on the weighted average number of
shares outstanding immediately prior to the closing of the Offering, after
giving effect to a 34,875-for-1 stock split and the shares issued in the
Offering.
F-24
<PAGE>
Happy Kids Inc. and Subsidiaries
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
<TABLE>
<CAPTION>
Column A Column B Column C Column D Column E
-------- -------- -------- -------- --------
Additions
---------
(1) (2)
Balance at Charged to Charged to Balance at
beginning costs and other end of
Description of period expenses accounts Deductions(a) period
----------- ---------- ---------- ---------- ------------- ----------
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1996
Deducted from asset accounts
Allowance for doubtful accounts $274 $13 $199 -- $ 486
Year ended December 31, 1997
Deducted from asset accounts
Allowance for doubtful accounts
and other receivables $486 $31 $323 -- $ 840
Year ended December 31, 1998
Deducted from asset accounts
Allowance for doubtful accounts
and other receivables $840 $71 $838 -- $1,749
- -------------
(a) Accounts written off as uncollectible.
</TABLE>
HAPPY KIDS INC.
CHANGE IN CONTROL SEVERANCE PAY AGREEMENT
THIS CHANGE IN CONTROL SEVERANCE PAY AGREEMENT (the "Agreement") is made
as of the 12th day of January, 1999, by and between Happy Kids Inc., a New York
corporation (the "Company"), and Stuart Bender, an employee of the Company (the
"Employee").
Recitals:
--------
1. The Company is a designer and marketer of custom-designed, licensed and
branded children's apparel and produces high quality, coordinated apparel
programs. The Employee is currently employed by the Company as the Chief
Financial Officer.
2. The Company and the Employee desire to provide for the payment, in certain
instances, of severance pay to the Employee in the event of the
termination of Employee's employment following a change of control of the
Company, on the terms and conditions set forth in this Agreement:
Agreement:
---------
In consideration of the premises and the mutual covenants and conditions
set forth herein, the Company and the Employee agree as follows:
Section 1. Operation of Agreement. This Agreement shall be effective
----------------------------------
immediately upon its execution, but the provisions hereof shall not be operative
unless and until a "Change in Control" (as such term is defined in Section 2
hereof) has occurred. The provisions of this Agreement shall not be operative
and shall not apply to any termination of employment, for any reason, which
--- -----
occurs before the period beginning three months and one day prior to a Change in
Control or which occurs after the period beginning one year and one day after a
Change in Control.
Section 2. Change in Control. The term "Change in Control" as used in this
----------------------------
Agreement shall mean the first to occur of any of the following:
(a) The effective date or date of consummation of any transaction or
series of transactions (other than a transaction to which only the Company
and one or more of its subsidiaries are parties) pursuant to which the
Company:
(i) becomes a subsidiary of another corporation; (ii) is merged or
consolidated with or into another corporation; (iii) engages in an
exchange of shares with another corporation; or (iv) transfers, sells
or otherwise disposes of all or substantially all of its assets to a
single purchaser (other than the Employee) or a group of purchasers
(none of whom is the Employee);
<PAGE>
provided, however, that this Subsection (a) shall not be applicable to a
-------- -------
transaction or series of transactions in which a majority of the capital
stock of the other corporation, following such transaction or series of
transactions, is owned or controlled by the holders of a majority of the
Company's outstanding capital stock immediately before such sale, transfer
or disposition; or
(b) The date upon which any person (other than the Employee), group of
associated persons acting in concert (none of whom is the Employee) or
corporation becomes a direct or indirect beneficial owner of shares of
stock of the Company representing an aggregate of more than fifty percent
(50%) of the votes then entitled to be cast at an election of directors of
the Company; and provided, however, that the acquisition of shares in a
-------- -------
bona fide public offering or private placement of securities by an
---- ----
investor who is acquiring such shares for passive investment purposes only
shall not constitute a "Change in Control;" or
(c) The date upon which the persons who were members of the Board of
Directors of the Company as of the date hereof (the "Current Directors")
cease to constitute a majority of the Board of Directors; provided,
--------
however, that any new director whose nomination or selection has been
-------
approved by the affirmative vote of at least three (3) of the Current
Directors then in office shall also be deemed a Current Director.
Section 3. Severance Pay Upon Termination by Company Without Cause or By
--------------------------------------------------------------------------
Employee for Cause. If, during the three-month period immediately preceding a
- ------------------
Change in Control or during the one-year period immediately following a Change
in Control, the Employee's employment with the Company is terminated:
(a) By the Company for no reason or for any reason other than:
(i) death; (ii) disability (in the event that the Employee shall be
unable to perform Employee's duties for a period of ninety (90)
consecutive calendar days by reason of disability as a result of
illness, accident or other physical or mental incapacity or
disability); or (iii) the dishonest or willful misconduct of the
Employee, including but not limited to: misappropriating any funds or
property of the Company; attempting to willfully obtain any personal
profit from any transaction in which the Employee has an interest
which is adverse to the interests of the Company; any act or omission
which substantially impairs the Company's ability to conduct its
ordinary business in its usual manner; unreasonable neglect or refusal
to perform the duties assigned to the Employee; conviction of a
felony; or any other act or omission which subjects the Company or any
of its subsidiaries to substantial public disrespect, scandal or
ridicule; or
2
<PAGE>
(b) By the Employee as a result of, or within thirty (30) days of the
following:
(i) a reduction in Employee's rate of regular compensation from the
Company to an amount below the rate of Employee's regular compensation
as in effect immediately prior to Employee's termination or
immediately prior to the Change in Control, as applicable; (ii) a
requirement that the Employee relocate to a location more than
thirty-five (35) miles from the Employee's office location with the
Company immediately prior to Employee's termination or immediately
prior to the Change in Control, as applicable; or (iii) a change in
duties or job responsibilities from those in effect immediately prior
to Employee's termination or immediately prior to the Change in
Control, as applicable, which change results in the diminution of the
Employee's status, authority and duties, except for such subordination
in duties or job responsibilities as may normally be required due to
the Company's change from an independent business entity to being a
subsidiary or division of another corporate entity;
then, in the event such termination occurred during the three-month period
immediately preceding such Change in Control, the Company shall pay the
Severance Amount (hereinafter defined) within thirty (30) days of the occurrence
of the Change in Control, or, in the event such termination occurred during the
one-year period following the occurrence of the Change in Control, the Company
shall pay the Employee, within thirty (30) days after the effective date of
Employee's termination, the Severance Amount. For purposes of this Agreement,
Severance Amount shall mean an amount equal to three (3) times the sum of the
rate of Employee's annual regular compensation as in effect immediately prior to
Employee's termination or immediately prior to the Change in Control, as
applicable, plus an amount equal to the bonus, if any, paid to the Employee in
the year prior to such termination or Change in Control. The Company may
withhold from any such severance compensation any federal, state, city, county
or other taxes. If the Severance Amount is due to the Employee hereunder and the
termination occurred during the three-month period immediately preceding the
Change in Control, then the Company shall also be obligated to reimburse the
Employee, upon receipt of appropriate receipts for such payments, for actual
amounts which are otherwise unreimbursable or unfunded by any other employer and
which were or are expended by the Employee to obtain, for a maximum of six
months from the date of termination, comparable insurance benefits as are
customarily provided to employees of the Company. If the Severance Amount is due
to the Employee hereunder and the termination occurred during the one-year
period immediately following the Change in Control, then the Company shall also
be obligated to provide the Employee with insurance benefits for six months
following termination of Employee's employment; provided, however, that if the
-------- -------
Employer begins employment with an employer other than the Company during such
six months, then such benefits shall cease to be owed or owing on the date the
Employee begins such employment with such other employer; and provided further,
-------- -------
that in the event that the Employee's continued participation in any such plans
for such period is not possible under the general terms and provisions thereof,
the Company shall pay to the Employee benefits which are substantially similar
in content and value to those which the
3
<PAGE>
Employee was entitled under such plans or programs for such period.
Except as set forth in Section 5 hereto, with respect to options held by
the Employee, if any, if the Severance Amount is paid pursuant to this Section
3, such payment shall constitute the entire obligation of the Company to the
Employee and full settlement of any claim under law or equity that the Employee
might otherwise assert against the Company, or any of its employees, officers or
directors on account of the Employee's termination.
Section 4. No Severance Pay Upon Any Other Termination. Upon any
--------------------------------------------------------------
termination of the Employee's employment with the Company other than as set
forth in Section 3 hereto, and except as set forth in Section 5 hereto, with
respect to options held by the Employee, if any, the sole obligation hereunder
of the Company shall be to pay Employee's regular compensation up to the
effective date of termination. In such event, however, the severance pay
provisions hereunder will not impact in any way the rights of the Employee or
the obligations of the Company under any employment agreement or any other
agreement for the payment of employment compensation between the Employee and
the Company, whether such agreement(s) are in existence now or come into
existence hereafter.
Section 5. Entire Obligation. Payment to the Employee pursuant to either
-----------------------------
of Section 3 or 4 of this Agreement (provided that if payment is made pursuant
to Section 4 hereof, the Company has met its obligations under any employment
agreement or any other agreement for the payment of employment compensation
between the Employee and the Company) shall constitute the entire obligation,
pursuant to each such respective Section, of the Company to the Employee and
full settlement of any claim under law or equity that the Employee might
otherwise assert against the Company, or any of its employees, officers or
directors on account of the Employee's termination; provided, however, that in
the event the Employee shall have options outstanding as of the date of
Employee's termination, such options shall continue to be governed by the terms
thereof, regardless of whether the Employee receives compensation pursuant to
Section 3 or 4 hereof.
Section 6. No Obligation To Continue Employment. This Agreement does not
------------------------------------------------
create any obligation on the part of the Company to continue to employ the
Employee following a Change in Control or in the absence of a Change in Control.
Section 7. Term of Agreement. This Agreement shall terminate and no longer
----------------------------
be in effect on the earlier of: (i) December 31, 2008; (ii) the date upon which
the Employee ceases to be an employee of the Company, unless a Change in Control
occurs within three months after such termination date; or (iii) if a Change in
Control occurs while the Employee is employed by the Company, until the date one
year following the Change in Control.
Section 8. Severability. Should any clause, portion or section of this
------------------------
Agreement be unenforceable or invalid for any reason, such unenforceability or
invalidity shall not affect the enforceability or validity of the remainder of
the Agreement.
Section 9. Assignment: Successors in Interest. This Agreement, being
------------------------------------------------
personal to the Employee, may not be assigned by the Employee. The terms and
conditions of this Agreement
4
<PAGE>
shall inure to the benefit of and be binding upon the successors and assigns of
the Company, and the heirs, executors and personal representatives of the
Employee.
Section 10. Waiver. Failure to insist upon strict compliance with any of
------------------
the terms, covenants or conditions of this Agreement shall not be deemed a
waiver of such term, covenant or condition, nor shall any waiver or
relinquishment of any right or power hereunder at any one or more times be
deemed a waiver or relinquishment of such right or power at any other time or
times.
Section 11. Governing Law. This Agreement shall be governed by and
----------------------------
construed in accordance with the laws of the State of New York applicable in the
case of agreements made and to be performed entirely within such State.
Section 12. Arbitration. Any controversy or claim arising out of or in
------------------------
connection with this Agreement shall be settled by arbitration in accordance
with the rules of the American Arbitration Association then in effect in the
State of New York and judgment upon such award rendered by the arbitrator may be
entered in any court having jurisdiction thereof. The arbitration shall be held
in the State of New York. The arbitration award shall include attorneys' fees
and costs to the prevailing party.
* * * * * *
5
<PAGE>
IN WITNESS WHEREOF, this Agreement has been executed by the undersigned as
of the date first above written.
HAPPY KIDS INC.
By: /s/ Jack Benun
-----------------------------------------
Jack Benun,
President and Chief Executive Officer
THE EMPLOYEE
/s/ Stuart Bender
----------------------------------------------
Stuart Bender
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE AUDITED
CONSOLIDATED FINANCIAL STATEMENTS AT DECEMBER 31, 1998 AND FOR THE TWELVE MONTH
PERIOD ENDED DECEMBER 31, 1998 WHICH ARE INCLUDED IN THE REGISTRANT'S FORM 10-K
AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0001052262
<NAME> Happy Kids Inc.
<MULTIPLIER> 1,000
<CURRENCY> U.S. Dollars
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<EXCHANGE-RATE> 1
<CASH> 139
<SECURITIES> 0
<RECEIVABLES> 20,640
<ALLOWANCES> (513)
<INVENTORY> 23,579
<CURRENT-ASSETS> 47,992
<PP&E> 1,459
<DEPRECIATION> (1,570)
<TOTAL-ASSETS> 50,452
<CURRENT-LIABILITIES> 11,697
<BONDS> 3,753
0
0
<COMMON> 103
<OTHER-SE> 32,428
<TOTAL-LIABILITY-AND-EQUITY> 50,452
<SALES> 154,559
<TOTAL-REVENUES> 154,559
<CGS> 113,796
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 22,449
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 2,077
<INCOME-PRETAX> 16,237
<INCOME-TAX> 4,603
<INCOME-CONTINUING> 11,634
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 11,634
<EPS-PRIMARY> 1.21 <F1>
<EPS-DILUTED> 1.21 <F2>
<FN>
<F1> This amount represents Basic Earnings per Share in accordance with the
requirements of Statement of Financial Accounting Standards No. 128 -
"Earnings per Share".
<F2> This amount represents Diluted Earnings per Share in accordance with
the requirements of Statement of Financial Accounting Standards No.
128 - "Earnings per Share".
</FN>
</TABLE>
