10-Q 1 d10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the thirteen week period ended July 1, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ----------------- ------------------- Commission File No. 1-11368 PARAGON TRADE BRANDS, INC. (Exact name of registrant as specified in its charter) Delaware 91-1554663 -------- ---------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 180 Technology Parkway Norcross, Georgia 30092 ------------------------ (Address of principal executive offices) (678) 969-5000 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate by check mark whether the Registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes X No ----- ----- The number of shares outstanding of the registrant's common stock was 11,996,300 shares ($.01 par value) as of July 1, 2001. PARAGON TRADE BRANDS, INC. Index to Form 10-Q Filing For the thirteen week period ended July 1, 2001

-2- PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS PARAGON TRADE BRANDS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Dollar amounts in thousands except per share data) (Unaudited)

-3- PARAGON TRADE BRANDS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Continued) (Dollar amounts in thousands except per share data) (Unaudited)

------------- (1) Contractual interest - Total interest expense which, due to bankruptcy proceedings, only portions of the contractual interest were deemed payable and recognized as interest expense. (2) Financial statements for year 2000 have been restated to reflect that certain investments in unconsolidated subsidiaries have been changed from the cost method to the equity method of accounting. See Accompanying Notes to Condensed Consolidated Financial Statements. -4- PARAGON TRADE BRANDS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (Dollar amounts in thousands, except share data) (Unaudited)

See Accompanying Notes to Condensed Consolidated Financial Statements. -5- PARAGON TRADE BRANDS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollar amounts in thousands) (Unaudited)

-6- PARAGON TRADE BRANDS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (Dollar amounts in thousands) (Unaudited)

See Accompanying Notes to Condensed Consolidated Financial Statements. -7- PARAGON TRADE BRANDS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS For the Thirteen and Twenty-Six Week Period Ended July 1, 2001 (Dollar amounts in thousands except share and per share data) (Unaudited) Note 1: Chapter 11 Proceedings and Reorganization On January 28, 2000, we emerged from Chapter 11 protection as contemplated by a Second Amended Plan of Reorganization (the "Plan") and a related Disclosure Statement, the terms of which included an investment by Wellspring Capital Management LLC ("Wellspring"), and withdrawal of appeals of settlements of our patent infringement lawsuits with The Procter & Gamble Company ("P&G") and Kimberly-Clark Corporation ("K-C"). In connection with the emergence from Chapter 11 protection, all of our pre- petition obligations were discharged. We recorded the reorganization and related transactions using "fresh start" accounting as required by Statement of Position 90-7 ("SOP 90-7") issued by the American Institute of Certified Public Accountants. "Fresh start" accounting was required because there was more than a 50 percent change in our ownership and the reorganization value of the assets was less than the post-petition liabilities and allowed claims in the bankruptcy. In connection with the recording of "fresh start" accounting, we recorded an extraordinary gain of $123,043 in 2000 related to discharge of debt. A more expanded discussion of these events can be found in our annual report on Form 10-K for the year ended December 31, 2000. Note 2: Basis of Presentation and Summary of Significant Accounting and Reporting Policies Basis of Presentation The condensed consolidated financial statements include the accounts of Paragon Trade Brands, Inc. and its majority-owned subsidiaries. All significant intercompany transactions and accounts have been eliminated. In March 2001, through Paragon Trade Brands International, Inc. ("PTBI"), a wholly owned subsidiary of Paragon, we gave effect to a series of transactions with our Mexican joint venture partner to increase our ownership in Paragon- Mabesa International, S.A. de C.V. ("PMI") and Grupo P.I. Mabe, S.A. de C.V. ("Grupo Mabe") from 49 to 51 percent and 15 to 20 percent, respectively. As a result of these transactions, the accompanying condensed consolidated financial statements have been prepared with PMI under the consolidation method beginning at the acquisition date and with Grupo Mabe changed from the cost method to the equity method effective in the first quarter of 2001. Accordingly, all prior periods presented have been restated for the change in our Grupo Mabe investment. (See "Note 4 to Condensed Consolidated Financial Statements.") The accompanying condensed consolidated balance sheet as of December 31, 2000, which has been derived from audited financial statements, and the unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information presented not misleading. It is suggested that these condensed consolidated financial statements be read in conjunction with the financial statements and the notes thereto included in our latest annual report on Form 10-K. In the opinion of management, all adjustments necessary for a fair presentation of the results of the interim periods have been included. All such interim adjustments are of a normal recurring nature except for the bankruptcy-related costs, the loss on the Stronger Corporation S.A. ("Stronger") percentage of ownership change, the loss from discontinued operations and the extraordinary gain. The results of operations for the twenty-six week period ending July 1, 2001 should not be regarded as necessarily indicative of the results that may be expected for the full year. New Accounting Standards The Emerging Issues Task Force of the Financial Accounting Standards Board (the "Task Force") reached a consensus on Issue 00-25, "Vendor Income Statement Characterization of Consideration from a Vendor to a Retailer". The issue addresses the income statement classification for slotting fees, cooperative advertising -8- arrangements and buydowns. Upon application of the consensus, which is required for the Company beginning in the first quarter of 2002, prior period financial statements should be reclassified to conform to the consensus. To date, the Company has not implemented the change but we do not believe the adoption will have a material impact on the overall financial statements. However, the reclassification from selling, general and administrative expenses ("SG&A") to sales, net of discounts and allowances is expected to have a significant impact on the SG&A line item. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 142, ("SFAS 142"), "Accounting for Goodwill and Other Intangibles". Under SFAS 142 goodwill and indefinite lived intangible assets are no longer amortized but are reviewed annually (or more frequently if impairment indicators arise) for impairment. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. Companies are required to immediately adopt the amortization provisions of SFAS 142 as it relates to goodwill and intangible assets acquired after June 30, 2001. With respect to goodwill and intangible assets acquired prior to July 1, 2001, companies are required to adopt SFAS 142 in their fiscal year beginning after December 15, 2001. SFAS 142 may not be applied retroactively. The Company anticipates adopting SFAS 142 in accordance with its provisions. The adoption of SFAS 142 is expected to increase earnings from continuing operations by approximately $2,400 per year. Note 3: Inventories Inventories consist of the following:

Note 4: Changes in Ownership In March 2001, through PTBI, a wholly owned subsidiary of Paragon, we gave effect to a series of transactions with our Mexican joint venture partner. As a result of these transactions, PTBI: - increased its ownership interest in PMI from 49 percent to 51 percent and the Mexican shareholder reduced his ownership interest accordingly. We paid cash of $500 for the purchase of the additional 2 percent ownership interest. As a result of this transaction, the accompanying condensed consolidated financial statements include PMI's financial results and balance sheet under the consolidation method beginning at the acquisition date of March 15, 2001. The consolidation of PMI resulted in the reclassification of a component of "Investment in and advances to unconsolidated subsidiaries, at equity" to goodwill on the condensed consolidated balance sheet; - increased its ownership interest in Grupo Mabe from 15 percent to 20 percent and the Mexican shareholder reduced his ownership interest accordingly. We paid cash of $14,202 for the purchase of the additional 5 percent ownership interest. As a result of this transaction, effective in the first fiscal quarter of 2001, we changed from the cost method to the equity method in accounting for our investment in Grupo Mabe. Accordingly, the condensed consolidated financial statements of all prior periods presented have been restated. In connection with this transaction, PTBI's existing option to purchase an additional 34 percent interest in Grupo Mabe at a contractually determined exercise price was terminated. Grupo Mabe is the holding company of a group of entities in Mexico, whose principal activity is the manufacture of baby diapers and other sanitary articles. The restatement's impact on earnings (loss) from continuing operations -9- and on net income for each of the quarters in 2000 was income of $280, $1,064, $863 for the first, second and third quarter, respectively, and a loss of $256 for the fourth quarter. Basic and diluted earnings per share were $.02, $.09, $.07 for the first, second and third quarter, respectively, and $(.02) for the fourth quarter. Given the relatively small changes in the denominators, the year to date per share amounts are the same as the sum of the individual periods. - reduced its ownership interest in Stronger from 49 percent to 20 percent and our co-shareholder increased its ownership interest accordingly. Paragon will continue to account for its investment in Stronger under the equity method. We recorded an estimated loss of $1,953 on the sale of our 29 percent ownership interest during the first quarter, and in the second quarter we recorded an additional loss of $293. Stronger is a financial investment corporation that holds interests in companies that manufacture, distribute and sell disposable diapers, skin lotions for children and other personal care products primarily in Argentina, Colombia and Brazil. Through PTBI, we also entered into an option agreement with the majority Mexican shareholder of Grupo Mabe and PMI, pursuant to which, under certain circumstances (including a change of control of Paragon or PTBI), each of PTBI and the Mexican shareholder have certain "put" and "call" rights in respect of their respective interests in PMI and Grupo Mabe, in each case at contractually determined exercise prices. Note 5: Summary Pro Forma Information on the Consolidation of PMI The accompanying condensed consolidated financial statements for the thirteen and twenty-six weeks ended July 1, 2001 have been prepared with PMI consolidated as of the date of acquisition beginning March 15, 2001. This transaction has been recorded by including the results of PMI beginning January 1, 2001, and deducting, under the caption "minority interest", PMI's earnings for the period from January 1, 2001 to March 15, 2001. The table below represents pro forma financial information for the twenty-six weeks ended July 1, 2001 and June 25, 2000 as if PMI had been consolidated on January 1, 2001 and December 27, 1999, respectively. These unaudited pro forma results of operations do not purport to represent what our actual results of operations would have been if the acquisition had occurred on January 1, 2001 and December 27, 1999, respectively, and should not serve as a forecast of our operating results for any future periods.

-10- Note 6: Discontinued Operation On August 10, 2000, we made a decision to concentrate on our core infant care business with the intent to sell our Gaffney, South Carolina femcare and adult incontinence segment. The expected disposal date depends on market factors as we continue to work towards liquidating the assets of the segment. That segment ceased manufacturing operations in October 2000. Our condensed consolidated financial statements for all periods presented have been restated to reflect the discontinued operations. Assets of the discontinued operation have been reflected in the condensed consolidated balance sheet as current or non-current based on the nature of the amounts. No liabilities are anticipated to be assumed by a third party and therefore they are reflected in continuing operations. The following is a summary of the assets of the discontinued operation:

The reduction in current assets from December 31, 2000 represents the continued sale of product and collection of receivables. The reduction of non-current assets represents the disposition of equipment. We received proceeds during the twenty-six week period ended July 1, 2001 of $3,578 from equipment sales. For the thirteen and twenty-six weeks ended June 25, 2000 we reported a loss from operations of $3,752 and $6,811, respectively. No losses from operations have been incurred in 2001. Net sales of the discontinued operation for the thirteen and twenty-six weeks ended July 1, 2001 and June 25, 2000 were $607, $1,412, $3,221 and $6,795, respectively. Note 7: Income Taxes We account for income taxes based on the liability method and, accordingly, deferred income taxes are provided to reflect temporary differences between financial and tax reporting. We have recorded a valuation allowance for substantially all deferred tax assets as we do not believe it is more likely than not that the benefits will be realized. A significant component of deferred income taxes include temporary differences due to reserves not currently deductible ($46,944) and operating loss carryforwards ("NOLs") ($22,307). These deferred tax assets may only be realized as an offset to future taxable income. Also, the ability to utilize a portion of the NOLs and the other deferred tax assets is subject to limitation under Section 382 of the Internal Revenue Code as a result of the change in ownership that occurred in connection with the bankruptcy reorganization. To realize the full benefit of the deferred tax assets, we need to generate approximately $217,135 in future taxable income. Accordingly, we have estimated that the limitation on the annual utilization of built-in deductions will be approximately $6,800. We currently have fully reserved our net deferred tax asset of $83,597. -11- Note 8: Comprehensive Income (loss) The following are the components of comprehensive income (loss):

Note 9: Earnings (Loss) Per Common Share Following is a reconciliation of the numerators and denominators of the basic and diluted earnings (loss) per common share from continuing operations:

There were no options or warrants outstanding for the five weeks ended January 28, 2000. Options to purchase 700,000 shares were outstanding during the twenty-six weeks ending June 25, 2000, but were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price. Warrants to purchase 625,842 shares were outstanding during the thirteen and twenty-six weeks ended July 1, 2001 and June 25, 2000, but were not included in the computation of diluted earnings per share because the exercise price of the warrants was greater than the average market price. -12- Note 10: Reimbursable Deal Costs Pursuant to an Order Approving Paragon Trade Brands, Inc. as Initial Bidder and Establishing Acquisition Procedures for the Sale of the Debtor's Business, dated December 22, 2000, the United States Bankruptcy Court for the Southern District of Texas, Houston Division, presiding over the Chapter 11 case of Drypers Corporation ("Drypers") approved the payment by Drypers to us of our reasonable expenses (including the reasonable fees and expenses of our counsel and other advisors) incurred in connection with a proposed acquisition transaction with Drypers under certain circumstances. The Order provided for the reimbursement of our reasonable expenses incurred in connection with a letter of intent between us and Drypers dated December 22, 2000, as amended (the "LOI"), and/or the definitive documentation contemplated by the LOI, through the date of termination or breach of the LOI and/or the definitive documentation by Drypers. Drypers terminated the LOI on January 26, 2001, and we therefore contend that we are entitled to reimbursement of our expenses by Drypers through the date of termination. Drypers disputes our right to such reimbursement, apparently on the basis that they purportedly did not terminate the LOI. We filed a request for payment of the expense reimbursement in Drypers' Chapter 11 case in July 2001. On July 10, 2001, we filed our application in the Bankruptcy Court to compel payment of the expense reimbursement in the amount of $859. The hearing on the application has been scheduled for August 29, 2001. Drypers has confirmed to us that if its Chapter 11 plan is confirmed before that date Drypers will reserve the amount of the requested expense reimbursement pending the Bankruptcy Court's determination on the merits of our application. Paragon's request for expense reimbursement will be subject to Bankruptcy Court approval. Management believes that it is probable that the Bankruptcy Court will approve the expense reimbursement request over Drypers' anticipated objection. -13- PART I. FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION PARAGON TRADE BRANDS, INC. Results of Operations Effective January 28, 2000, we emerged from Chapter 11 bankruptcy proceedings and implemented "fresh start" accounting. Accordingly, all assets and liabilities were restated to reflect their respective fair values. The condensed consolidated financial statements after that date are those of a new reporting entity and are not comparable to the Pre-Confirmation periods. However, for analysis purposes, the twenty-one weeks ended June 25, 2000 (Post- Confirmation) have been combined with the five weeks ended January 28, 2000 (Pre-Confirmation) and then compared to the twenty-six weeks ended July 1, 2001. Differences between periods due to "fresh start" accounting adjustments are explained when necessary. The following table is included solely for use in comparative analysis of results of operations, and to complement management's discussion and analysis:

Thirteen Weeks Ended July 1, 2001 Compared to Thirteen Weeks Ended June 25, 2000 Net income was $10.2 million in the second quarter of 2001 compared to a net loss of $0.9 million in the second quarter of 2000. Included in the results for the second quarter of 2001 were non-recurring items of $0.9 million primarily for professional fees. The results for the second quarter of 2000 included non- recurring items of $3.2 million primarily due to severance costs to former senior management. In addition, the second quarter of 2000 was negatively impacted by losses associated with our feminine care and adult incontinence segment, which was discontinued in August of 2000. Excluding the non-recurring items discussed above, higher volumes, product mix, and improved manufacturing efficiencies contributed to improved results during the second quarter of 2001 compared to the second quarter of 2000. -14- Net Sales Net sales of infant diapers and training pants increased 40 percent to $179.8 million in the second quarter of 2001 compared to $128.6 million in the second quarter of 2000. The increase in net sales was due to increased volumes for both diapers and training pants. Total unit sales increased 35 percent to 1,095 million units in the second quarter of 2001 compared to 811 million units in the second quarter of 2000. This increase was due to expanding sales to existing customers and continued success with destination store brand programs, as well as growing market acceptance of our training pant product line. Additionally, the product mix for the time period resulted in an increase in the average selling price per unit. Price increases implemented in late 2000 were partially offset by an increase in the percentage of sales to our largest customers, who generally pay a lower average selling price. As a result of the increased volume, we continued to aggressively expand our capacity during the second quarter of 2001. Until new capacity is operational, we may experience difficulty in satisfying all of our customers' demand in the short-term. Cost of Sales Cost of sales in the second quarter of 2001 was $134.0 million compared to $107.6 million in the second quarter of 2000. As a percentage of net sales, cost of sales was 74.6 percent in the second quarter of 2001 compared to 83.7 percent in the second quarter of 2000. This decrease in costs as a percentage of sales was substantially due to favorable product mix, increased volume, improved manufacturing efficiencies, lower waste levels, and a reduction in certain raw material costs. Depreciation expense increased to $7.0 million for the second quarter of 2001 as compared to $4.9 million in the second quarter of 2000 driven by capacity-related capital investments and the consolidation of PMI. Selling, General and Administrative Expenses Selling, general and administrative expenses ("SG&A") were $20.0 million in the second quarter of 2001 compared to $16.3 million in the second quarter of 2000. As a percentage of net sales, these expenses were 11.1 percent in the second quarter of 2001 compared to 12.7 percent in 2000. The decrease in SG&A as a percentage of sales is partially attributable to the relatively fixed nature of administrative costs over a higher volume base in the second quarter of 2001. We believe SG&A expenses may increase from second quarter levels for the remainder of 2001, due to increased sales and market development expenditures. Research and Development Expense Research and development expense increased slightly to $1.3 million in the second quarter of 2001 compared to $1.0 million in the second quarter of 2000. The increase was primarily related to increased product development activity. Interest Expense Interest expense was $4.1 million in the second quarter of 2001 compared to $4.3 million in the second quarter of 2000. Interest costs for both quarters are associated with our $146.0 million of 11.25 percent senior subordinated notes that were issued on January 28, 2000. The second quarter of 2000 also includes interest associated with bank borrowings under our credit facility. There were no bank borrowings under our credit facility during the second quarter of 2001. Other Income (Expense), Net Other income (expense), net was income of $0.5 million in the second quarter of 2001 compared to $0.8 million in the second quarter of 2000. The decrease is primarily due to the elimination of intercompany interest now that PMI is consolidated. -15- Equity in Earnings of Unconsolidated Subsidiaries The equity in earnings of unconsolidated subsidiaries was $0.4 million in the second quarter of 2001 compared to $2.5 million in the second quarter of 2000. As previously discussed in Note 4, in the first quarter of 2001 we purchased an additional 2 percent of PMI, our Tijuana, Mexico joint venture, increasing our ownership to 51 percent and began accounting for PMI on the consolidation method. In 2000, PMI was accounted for and reported under the equity method. As a result of this change in reporting for PMI operations, the second quarter of 2001 does not include any PMI equity in earnings of unconsolidated subsidiaries compared to $2.2 million during the second quarter of 2000. Income Taxes During the second quarter of 2001, we recorded a tax provision of $9.3 million compared to a tax benefit of $0.3 million during the second quarter of 2000 driven by the greater profitability discussed previously. We have recorded a valuation allowance for substantially all deferred tax assets as we do not believe it more likely than not that the benefits will be realized. During the second quarter of 2001, we recorded an income tax provision primarily related to Section 382 limitations on the utilization of our domestic net operating losses and foreign withholding taxes paid. During the second quarter of 2000, income tax benefits associated with domestic operating losses and deductible temporary differences for the periods presented have been fully reserved with a valuation allowance on the basis that the realization of such benefits is dependent upon sufficient taxable income in the future. We have recorded a valuation allowance for substantially all deferred tax assets as we do not believe it is more likely than not that the benefits will be realized. Income tax benefits recognized in the accompanying financial statements for the periods presented relate to recoverable income taxes for jurisdictions outside the United States. Twenty-Six Weeks ended July 1, 2001 Compared to Twenty-Six Weeks ended June 25, 2000 Results of Operations Net income was $17.6 million in the first half of 2001 compared to net income of $113.4 million in the first half of 2000. Included in the results for the first half of 2001 were non-recurring items of $2.9 million primarily for the loss on sale of a portion of our investment in Stronger and professional fees. The results for the first half of 2000 include an extraordinary gain of $123.0 million associated with forgiveness of debt that resulted from the reorganization of the Company in accordance with the Plan. In addition, the results for the first half of 2000 include non-recurring items of $3.5 million primarily due to severance costs to former senior management and losses of $6.8 million associated with our feminine care and adult incontinence segment. Excluding the non-recurring items discussed above, higher volumes, product mix, and improved manufacturing efficiencies contributed to improved results during the first half of 2001 compared to the first half of 2000. Net Sales Net sales of infant diapers and training pants increased 36 percent to $347.2 million in the first half of 2001 compared to $254.8 million in the first half of 2000. The increase in net sales was due to increased volumes for both diapers and training pants. Total unit sales increased 32 percent to 2,112 million units in the first half of 2001 compared to 1,601 million units in the first half of 2000. This increase was due to expanding sales to existing customers and continued success with destination store brand programs, as well as growing market acceptance of our training pant product line. Additionally, the product mix for the first half of 2001 resulted in an increase in the average selling price per unit. Price increases implemented in late 2000 were partially offset by an increase in the percentage of sales to our largest customers, who generally pay a lower average selling price. As a result of the increased volume, we continued to aggressively expand our capacity during the first half of 2001. Until new capacity is operational, we may experience difficulty in satisfying all of our customers' demand in the short-term. -16- Cost of Sales Cost of sales in the first half of 2001 was $260.6 million compared to $207.9 million in the first half of 2000. As a percentage of net sales, cost of sales was 75.1 percent in the first half of 2001 compared to 81.6 percent in the first half of 2000. This decrease in costs as a percentage of sales was substantially due to favorable product mix, increased volumes, improved manufacturing efficiencies, lower waste levels, and a reduction in certain raw material costs. Depreciation expense increased to $12.4 million for the first half of 2001 as compared to $9.9 million for the first half of 2000 driven by capacity-related capital investments and the consolidation of PMI. Selling, General and Administrative Expenses Selling, general and administrative expenses ("SG&A") were $38.9 million in the first half of 2001 compared to $34.5 million in the first half of 2000. As a percentage of net sales, these expenses were 11.2 percent in the first half of 2001 compared to 13.5 percent in 2000. The decrease in SG&A as a percentage of sales is partially attributable to the relatively fixed nature of administrative costs over a higher volume base in the first half of 2001. We believe SG&A expenses may increase from first half levels for the remainder of 2001 due to increased marketing and sales expenditures. Research and Development Research and development expenses increased to $2.5 million in the first half of 2001 compared to $2.0 million in the first half of 2000. The increase was primarily related to increased product development activity. Interest Expense Interest expense was $8.2 million in the first half of 2001 compared to $7.2 million in the first half of 2000. The increase is primarily due to interest costs associated with our $146.0 million of 11.25 percent senior subordinated notes being incurred for twenty-six weeks in 2001 compared to twenty-two weeks in 2000, since the notes were issued on January 28, 2000. Other Income (Expense), net Other income (expense), net was a loss of $1.1 million in the first half of 2001 compared to income of $1.0 million in the first half of 2000. The loss in the first half of 2001 was primarily attributable to our loss on the sale of 29 percent of our interest in Stronger. Equity in Earnings of Unconsolidated Subsidiaries The equity in earnings of unconsolidated subsidiaries was $0.8 million in the first half of 2001 compared to $3.1 million in the first half of 2000. As discussed in Note 4, in the first quarter of 2001, we purchased an additional 2 percent of PMI, increasing our ownership to 51 percent and we began accounting for PMI on the consolidation method. In 2000, PMI was accounted for and reported under the equity method. As a result of this change in reporting for PMI operations the first half of 2001 does not include any PMI equity in earnings of unconsolidated subsidiaries compared to $2.8 million during the first half of 2000. During the first quarter of 2001, we purchased an additional 5 percent interest of Grupo Mabe to increase our ownership of this Mexican manufacturer of diapers and absorbent care products to 20 percent. Our increased ownership in Grupo Mabe and their improved operating results were partially offset by increased losses in Stronger. Bankruptcy Costs We incurred no bankruptcy costs in the first half of 2001 compared to $10.4 million during the first half of 2000. These costs were primarily due to professional fees associated with the exit from bankruptcy as well as $3.3 million in confirmation bonuses paid to employees. We emerged from Chapter 11 protection on January 28, 2000 and have not incurred further bankruptcy expenses. -17- Extraordinary Gain from Discharge of Debt During the period ending January 28, 2000, we recorded an extraordinary gain of $123.0 million for the discharge of indebtedness that resulted from the forgiveness of certain liabilities in accordance with our plan of reorganization. Income Taxes During the first half of 2001, we recorded a tax provision of $16.3 million compared to a tax benefit of $0.3 million during the first half of 2000 driven by the greater profitability discussed previously. We have recorded a valuation allowance for substantially all deferred tax assets as we do not believe it more likely than not that the benefits will be realized. During the first half of 2001, we recorded an income tax provision primarily related to Section 382 limitations on the utilization of our domestic net operating losses and foreign withholding taxes paid. During the first half of 2000, income tax benefits associated with domestic operating losses and deductible temporary differences for the periods presented have been fully reserved with a valuation allowance on the basis that the realization of such benefits is dependent upon sufficient taxable income in the future. We have recorded a valuation allowance for substantially all deferred tax assets as we do not believe it is more likely than not that the benefits will be realized. Income tax benefits recognized in the accompanying financial statements for the periods presented relate to recoverable income taxes for jurisdictions outside the United States. Liquidity and Capital Resources During the first half of 2001, net cash provided by operating activities was $16.9 million compared to $0.9 million in the first half of 2000. Earnings improved in the first half of 2001 as compared to the first half of 2000, but this improvement was partially offset by increases in working capital. We used cash to build inventory levels to support growing sales and for payment of scheduled royalty, interest and annual incentive programs. During the first half of 2001, net cash used in investing activities was $26.4 million compared to net cash provided of $0.9 million in the first half of 2000. Cash usage during 2001 was largely driven by capital expenditures primarily related to capacity expansion as well as the net incremental investments that we have made in our joint ventures. These usages were partially offset by cash provided of $7.5 million as a result of consolidating PMI. Capital expenditures were $23.1 million for the first half of 2001 compared to capital expenditures of $5.0 million for the first half of 2000. Capital spending is expected to be approximately $55 million during 2001 and will be funded from internally generated funds and, if necessary, from borrowings under our credit facility. On January 28, 2000, we entered into a credit facility. The maximum borrowing under the credit facility may not exceed the lesser of $95.0 million or an amount determined by a borrowing base formula. The borrowing base formula is comprised of certain specified percentages of eligible accounts receivable, eligible inventory, equipment and personal property and real property of our Company. The credit facility has a sub-limit of $15.0 million for the issuance of letters of credit. As of July 1, 2001, we had no direct borrowings and $5.4 million in letters of credit outstanding under the credit facility. As of June 25, 2000, we had no direct borrowings and $5.1 million in letters of credit outstanding under the credit facility. On January 28, 2000, we issued $146.0 million of 11.25 percent senior subordinated notes due 2005. These notes are not callable until February 1, 2003. Interest is payable semi-annually and during the first two years can be paid in kind if free cash flow, as defined in the indenture, falls below projected levels. We have not paid interest in kind for any payment due in 2001 or 2000. Future Realization of Net Deferred Tax Asset We account for income taxes based on the liability method and, accordingly, deferred income taxes are provided to reflect temporary differences between financial and tax reporting. A significant component of deferred income taxes includes temporary differences due to reserves not currently deductible ($46.9 million) and operating loss carryforwards ("NOLs") ($22.3 million). These deferred tax assets may only be realized as an offset to future taxable income. Also, the ability to utilize a portion of the NOLs and the other deferred tax assets is subject to limitation under Section 382 of the Internal Revenue Code as a result of the change in ownership that occurred in connection with the bankruptcy reorganization. To realize the full benefit of the deferred tax asset, we need to -18- generate approximately $217.1 million in future taxable income. Accordingly, we have estimated that this limitation on the annual utilization of built-in deductions will be approximately $6.8 million. We have currently fully reserved our net deferred tax asset of $83.6 million. (See "Note 7 to Condensed Consolidated Financial Statements.") Risks and Uncertainties Increased Costs. As a part of the license agreements entered into in connection with our settlements with P&G and K-C, we have incurred and will continue to incur significant added costs in the form of royalties for sales of licensed diaper and training pant products. The royalties will have a material adverse impact on our future financial condition and results of operations as compared to pre-settlement. Our overall raw material costs increased during fiscal 2000 and our operating results may be adversely affected by any further increases in raw materials costs in the future. (See "Part II, Item 1 - Legal Proceedings.") Pricing. Prices for our products may come under competitive pressures from both the national branded as well as other store brand competitors. Should we not be able to maintain current pricing levels, our margins would be negatively impacted. Realization of Investment in Feminine Care and Adult Incontinence Business. As a part of our strategy we decided in August of 2000 to concentrate on our core infant care business and to liquidate the Gaffney, South Carolina femcare and adult incontinence pad-oriented segment. The expected disposal date depends on market factors as we continue to work towards liquidating the assets of the segment. While we have estimated the costs associated with the discontinuance of this segment, the actual costs could differ from such estimates. Branded Product Innovations. Because of the emphasis on product innovations in the disposable diaper market, patents and other intellectual property rights are an important competitive factor. The national branded manufacturers have sought to vigorously enforce their patent rights. Patents held by the national branded manufacturers could severely limit our ability to keep up with branded product innovations by prohibiting us from marketing products with comparable features. P&G and K-C have also heavily promoted diapers in the multi-pack configuration. These packages offer a lower unit price to the retailer and consumer. It is possible that we may realize lower selling prices and/or lower volumes as a result of these initiatives. Increased Financial Leverage. As a result of the issuance of debt in 2000 as previously discussed, our principal and interest obligations have increased substantially. The degree to which we are leveraged could adversely affect our ability to obtain additional financing for working capital, acquisitions or other purposes and could make us more vulnerable to economic downturns and competitive pressures. Our increased leverage could also adversely affect our liquidity and our ability to fund capital expenditures, as a substantial portion of available cash from operations will have to be used to meet debt service requirements. Based upon anticipated improvements in our operations and certain cost savings measures, we believe that our cash flows from operations, borrowings under the credit facility and other sources of liquidity will be adequate to meet our anticipated requirements for working capital, capital expenditures, interest payments and scheduled principal payments for the foreseeable future. There can be no assurance, however, that anticipated improvements in operations and cost savings will be realized. If we are unable to generate sufficient cash flows from operations in the future, we may be required to refinance all or a portion of our existing debt or obtain additional financing. There can be no assurance that any refinancing would be possible or that any additional financing could be obtained on terms that are favorable or acceptable to us. Patent Litigation Risk. We operate in an industry in which patents are numerous and are frequently enforced vigorously. We have been sued for patent infringement in the past and could be sued for patent infringement in the future. The distraction and expense of a patent infringement suit, and any damages awards, additional royalty payments or injunctions that result from a patent infringement suit, could adversely affect our financial condition and results of operations. Market for our Common Stock. Wellspring and its affiliates purchased 11,516,405 shares, or approximately 97 percent, of our common stock on January 28, 2000. A small amount of our outstanding common stock is traded sporadically on the National Association of Securities Dealers, Inc. Over-the-Counter Bulletin Board under the symbol PGTR. There can be no assurance that a liquid market will develop or be maintained for any of our outstanding securities. -19- Forward-Looking Statements From time to time, information provided by us, statements made by our employees or information included in our filings with the Securities and Exchange Commission (including in this Quarterly Report on Form 10-Q and the Annual Report on Form 10-K) may include statements that are not historical facts, so- called "forward-looking statements." The words "believes," "anticipates," "expects," and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in our forward-looking statements. Our actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors which could affect our financial results, including but not limited to: increased raw material prices and product costs; new product and packaging introductions by competitors; increased price and promotion pressure from competitors; and patent litigation, which are described herein and those discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2000. Readers are cautioned not to place undue reliance on the forward- looking statements, which speak only as of the date hereof, and which are made by management pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. We undertake no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK Our market risk-sensitive instruments and foreign currency exchange rate risks do not subject us to material market risk exposures. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On April 27, 2001, we initiated a private arbitration against Kimberly-Clark Corporation pursuant to the License Agreement between Kimberly-Clark Corporation and us dated March 15, 1999 (the "Enloe License"). In the arbitration, we seek a ruling that we do not owe running royalties under the Enloe License on our current products in light of the patent claim construction ruling in Kimberly- -------- Clark Corporation v. Tyco International (US), Inc., 98-C-756 (W.D. Wisc. Nov. 3, -------------------------------------------------- 1999), aff'd, 2001 WL 170461 (Fed. Cir. Feb. 20, 2001). We also seek recoupment ----- of all running royalties paid to Kimberly-Clark on sales occurring after November 3, 1999, with interest, and an award of attorney's fees. Kimberly- Clark has indicated that it opposes recoupment of past running royalties; that it believes at least some of Paragon's current products still require payment of a running royalty; and that if it wins the arbitration Kimberly-Clark will seek to be awarded the amount of all volume discounts previously enjoyed by Paragon under the Enloe License from March 15, 1999 to date and refuse to grant Paragon a volume discount going forward. Each party has selected its party-appointed arbitrator, and those arbitrators have identified a neutral chair for the panel. No schedule has been set and no procedures have been established for the conduct of the arbitration. We are engaged in settlement discussions in parallel with preparing for the arbitration. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Annual Meeting of Stockholders of the Company was held on May 24, 2001. The results of voting on the proposals submitted for vote at such meeting were as follows:

-20- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

** Confidential treatment has been requested as to a portion of this document. (1) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 26, 1999. (b) Reports on Form 8-K The Company filed a Current Report on Form 8-K containing information pursuant to Item 5 ("Other Events") dated June 20, 2001, disclosing that its majority shareholder was considering selling some or all of its investment in the Company. -21- Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PARAGON TRADE BRANDS, INC. By /s/ David C. Nicholson ---------------------------------------------------- David C. Nicholson Executive Vice President and Chief Financial Officer August 13, 2001 -22- EXHIBIT INDEX

PARAGON TRADE BRANDS INC 10-Q