10-Q 1 b39344fge10-q.txt AAI.FOSTERGRANT, INC. 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended March 31, 2001. [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from _______ to _______ Commission File Number 333-61119 AAI.FOSTERGRANT, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) RHODE ISLAND 05-0419304 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 500 GEORGE WASHINGTON HIGHWAY SMITHFIELD, RI 02917 --------------------------------------------------- (Address of principal executive offices) (Zip code) (401) 231-3800 --------------------------------------------------- (Registrant's telephone number, including area code) Indicate by checkmark 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: As of May 15, 2001, the aggregate market value of the voting equity held by non-affiliates of the Registrant was none. As of May 15, 2001, 608,000 shares of Common Stock, 43,700 shares of Series A Preferred Stock and 70,870 shares of Series B Preferred Stock of the Registrant were issued and outstanding. 2 AAI.FOSTERGRANT, INC. AND SUBSIDIARIES QUARTERLY REPORT TABLE OF CONTENTS PART I. - FINANCIAL INFORMATION PAGE ITEM 1. CONSOLIDATED CONDENSED FINANCIAL STATEMENTS Consolidated Condensed Balance Sheets as of December 30, 2000 and March 31, 2001 1 Consolidated Condensed Statements of Operations for the three months ended April 1, 2000 and March 31, 2001 2 Consolidated Condensed Statements of Cash Flows for the three months ended April 1, 2000 and March 31, 2001 3 Notes to Consolidated Condensed Financial Statements 4 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk 18 PART II - OTHER INFORMATION ITEM 1. Legal Proceedings 19 ITEM 2. Changes in Securities and Use of Proceeds 19 ITEM 3. Defaults Upon Senior Securities 19 ITEM 4. Submission of Matters to a Vote of Security Holders 19 ITEM 5. Other Information 19 ITEM 6. Exhibits and reports on Form 8-K 19 SIGNATURES 20 3 AAI.FOSTERGRANT, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED BALANCE SHEETS (In thousands)

The accompanying notes are an integral part of these consolidated condensed financial statements. 1 4 AAI.FOSTERGRANT, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (In thousands)

The accompanying notes are an integral part of these consolidated condensed financial statements. 2 5 AAI.FOSTERGRANT, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (In thousands)

The accompanying notes are an integral part of these consolidated condensed financial statements. 3 6 AAI.FOSTERGRANT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS Note 1 - Significant Accounting Policies (a) Interim Consolidated Condensed Financial Statements The accompanying unaudited interim consolidated condensed financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) for reporting on Form 10-Q. Accordingly, certain information and footnote disclosure required for complete financial statements are not included herein. It is recommended that these financial statements be read in conjunction with the consolidated financial statements and related notes of AAi.FosterGrant, Inc. (the "Company" or "AAi") for the year ended December 30, 2000 as reported in the Company's 10-K filed with the SEC on March 29, 2001. In the opinion of management, all adjustments (consisting of normal, recurring adjustments) considered necessary for a fair presentation of financial position, results of operations and cash flows at the dates and for the periods presented have been included. The consolidated condensed balance sheet presented as of December 30, 2000 has been derived from the consolidated financial statements that have been audited by the Company's independent public accountants. The results of operations for the period ended March 31, 2001 may not be indicative of the results that may be expected for the year ending December 29, 2001, or for any other future period. (b) Revenue Recognition The Company recognizes revenue from product sales, net of estimated agreed upon future allowances and anticipated returns and discounts, taking into account historical experience, upon shipment to the customer. (c) Inventories Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following at December 30, 2000 and March 31, 2001 (in thousands): DECEMBER 30, MARCH 31, 2000 2001 ------------ -------- Finished goods ....................... $26,881 $28,199 Work-in-process and raw materials .... 6,202 4,140 ------- ------- $33,083 $32,339 ======= ======= (d) Customer Acquisition Costs The Company incurs direct and incremental costs in connection with the acquisition of certain new customers and new store locations from existing customers under multi-year agreements. The Company may also receive the previous vendor's merchandise from the customer in connection with these agreements. In these situations, the Company values this inventory at its fair market value, representing the lower of cost or net realizable value, and records that value as inventory. The Company sells this inventory through various liquidation channels. Except as provided below, the excess costs over the fair market value of the inventory received is charged to selling expense when incurred. The Company expensed customer acquisition costs of approximately $88,000 and $13,000 for the three months ended April 1, 2000 and March 31, 2001, respectively. The excess costs over the fair market value of the inventory received is capitalized as deferred costs and amortized over the agreement period if the Company enters into a minimum purchase agreement with the customer from which the estimated gross profits from future minimum sales during the term of the agreement are sufficient to recover the amount of the deferred costs. During the three months ended April 1, 2000, the Company did not capitalize any of these costs. The Company capitalized costs of approximately $40,000 during the three months ended March 31, 2001. Amortization expense for the three months ended April 1, 2000 and March 31, 2001 related to previously capitalized costs was approximately $320,000 and $85,000, respectively. 4 7 Note 2 - Long-Term Obligations On July 21, 1998, the Company sold $75.0 million of 10 3/4% Senior Series A Notes due 2006 (the Notes) through a Rule 144A offering. The net proceeds of approximately $71.0 million received by the Company from the issuance and sale of the Notes were used to repay outstanding indebtedness under the Senior Credit Facility with a bank and the Subordinated Promissory Notes to shareholders, net of amounts due the Company from certain of these shareholders. The Company incurred issuance costs of approximately $3.7 million in relation to the Notes. These costs are being amortized over the life of the Notes and are included in other assets in the accompanying consolidated balance sheets. In December 1998, the Notes were exchanged for 10 3/4% Series B Notes due 2006 registered with the SEC. Interest on the Notes is payable semiannually on January 15 and July 15, commencing January 15, 1999. The Notes are general unsecured obligations of the Company, rank senior in right of payment to all future subordinated indebtedness of the Company and rank pari passu in right of payment to all existing and future unsubordinated indebtedness of the Company, including the Senior Credit Facility. The Senior Credit Facility is secured by a mortgage on its Smithfield, RI property, accounts receivable and inventory of the Company and its domestic subsidiaries. Accordingly, the Company's obligations under the Senior Credit Facility will effectively rank senior in right of payment to the Notes to the extent of the assets subject to such security interest. The Notes are fully and unconditionally guaranteed, on a senior and joint and several basis, by each of the Company's current and future Domestic Subsidiaries (as defined) (the Guarantors). The Indenture under which the Notes were issued (the Indenture) imposes certain limitations on the ability of the Company and its subsidiaries to, among other things, incur indebtedness, pay dividends, prepay subordinated indebtedness, repurchase capital stock, make investments, create liens, engage in transactions with shareholders and affiliates, sell assets and engage in mergers and consolidations. The Notes are redeemable at the option of the Company, in whole or in part, on or after July 15, 2002 at various redemption prices, declining from 105.375% of the principal amount to par on and after July 15, 2004. In addition, on or prior to July 15, 2001, the Company may use the net cash proceeds of one or more equity offerings to redeem up to 35% of the aggregate principal amount of the Notes originally issued at a redemption price of 110.750% of the principal amount thereof plus accrued interest to the date of redemption. Upon a change of control, each note holder has the right to require the Company to repurchase such holder's Notes at a purchase price of 101% of the principal amount plus accrued interest. During the second and third quarter of fiscal 2000, the Company repurchased $23.15 million face amount of the Notes for a purchase price of $7.09 million. The purchase price was financed utilizing a term loan under its existing Senior Credit Facility. The term loan is secured by a mortgage on its Smithfield, RI property and subject to the obligation of certain preferred shareholders to purchase participations in the term loan upon the happening of certain events. The term loan is being amortized over 60 months commencing April 1, 2001, with the principal balance due at the expiration of the Senior Credit Facility on July 31, 2003. As a result of this transaction, the Company recognized an $8.8 million extraordinary gain, net of $6.3 million in taxes, and wrote off $90,000 of unamortized issuance costs related to the Notes that were repurchased. These purchases resulted from inquiries from holders of the Notes. The Company does not solicit offers to tender Notes for repurchase, but may, from time to time, consider requests to repurchase Notes, subject to the availability of appropriate financing. In conjunction with the commitment to purchase participations in the term loan, the Company issued 70,870 shares of Series B Preferred Stock. The holders of Series B Preferred Stock are entitled to receive, prior and in preference to any distribution with respect to any other capital stock of the Company, an amount per share equal to $6.67 multiplied by the number of six month periods and fractions thereof in the period during which the participation commitment is outstanding. The Company is amortizing the value related to two six-month periods (approximately $945,000) as interest expense. If the participation commitment is outstanding for a period beyond twelve months, the Company will record additional value to the Series B Preferred Stock and amortize the related costs over the additional period of the participation commitment as required. Note 3 - Senior Credit Facility In March 2001, the Company amended its Senior Credit Facility. Borrowings under the Senior Credit Facility are limited to the lesser of $60.0 million or the borrowing base, which is defined as a percentage of eligible accounts receivable and the lesser of (i) inventories or (ii) $30.0 million less the interest rate protection reserve and the foreign exchange exposure, reduced by outstanding letters of credit. Revolving credit borrowings bear interest at the bank's prime rate (8.0% at March 31, 2001) plus 0.5% or LIBOR 5 8 (5.08% at March 31, 2001) plus 2.25%. The Company has the option of electing the rate; however, the use of LIBOR is limited. The Senior Credit Facility expires July 2003. As of March 31, 2001, the Company had approximately $3.4 million borrowing availability under the Senior Credit Facility. The Senior Credit Facility is subject to certain restrictive covenants, including a fixed charge coverage ratio, leverage ratio and minimum EBITDA. As of March 31, 2001, the Company was not in compliance with certain financial covenants. On May 14, 2001, the Company entered into a sixth amendment to the Senior Credit Facility which modified the financial covenants and waived non-compliance with the prior covenants. Note 4 - Comprehensive Loss Comprehensive loss for the three months ended April 1, 2000 and March 31, 2001 was $2.2 million and $3.1 million, respectively. Differences between comprehensive loss and loss before dividends and accretion on preferred stock for each period represents the foreign currency translation adjustment for each period. Note 5 - Restructuring Charge In March 2000, the Company recorded a restructuring charge of $2.5 million related to the termination of three executives. The charge consists of an accrual of severance payments due to three executives for a two-year period. The severance will be paid through fiscal 2002. Restructuring Charge Payments Payments Reserve Balance Description April 1, 2000 Fiscal 2000 Q1 2001 March 31, 2001 ----------- -------------------- ----------- -------- --------------- Severance benefits $2,500 $896 $692 $912 ====== ==== ==== ==== Note 6- Segment Reporting The Company has determined it has three reportable segments: mass merchandisers, chain drug stores/combo stores/supermarkets, and variety stores. The Company distributes accessories such as, costume jewelry, optical products, watches, clocks and other accessories. The Company's reportable segments are strategic business units that sell the Company's products to distinct distribution channels. They are managed separately because each business requires different marketing strategies. The Company's approach is based on the way that management organizes the segments within the enterprise for making operating decisions and assessing performance. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates performance based on profit or loss from operations before income taxes not including nonrecurring gains and losses.

6 9

Revenues from segments below the quantitative thresholds are attributable to five operating segments of the Company. Those segments include department stores, armed forces' PX stores, boutique stores, gift shops, bookstores and catalogues. None of these segments have ever met any of the quantitative thresholds for determining reportable segments and their combined results are presented as Other. Segment profit (loss) differs from the loss before income tax expense and dividends and accretion on preferred stock by the amount of other income, which is not allocated by segment. The chief operating decision-maker does not review segment assets. Total assets specifically identifiable with each reportable segment are as follows: DECEMBER 30, MARCH 31, 2000 2001 ------------ --------- Mass merchandisers $ 22,497 $ 24,123 Chain drug stores/combo stores/supermarkets 7,795 11,020 Variety 4,631 4,680 Other 2,701 3,839 Unassigned assets 70,547 57,319 -------- -------- $108,171 $100,981 ======== ======== Note 7 - Subsequent Event On April 6, 2001, the Company sold the majority of its remaining inventory related to the Fantasma product lines (watches and clocks) and related licenses to sell the product lines. The sales price of approximately $344,000 consisted of approximately $294,000 of cash and $50,000 to be placed in escrow to fund future customer credits taken on sales made by the Company prior to the transaction date. The Buyer did not assume trade receivables and remaining liabilities related to Fantasma. Note 8 - Supplemental Consolidating Financial Information The following is summarized consolidating financial information for the Company, segregating the Company, wholly owned guarantor subsidiaries and non-guarantor subsidiaries as they relate to the Notes. The wholly owned guarantor subsidiaries are domestic subsidiaries of the Company and they guarantee the Notes on a full, unconditional and joint and several basis. Separate financial statements of the guarantor subsidiaries have not been included because management believes that they are not material to investors. The Company and guarantor subsidiaries account for investments in subsidiaries on the equity method for the purposes of the consolidating financial data. Earnings of subsidiaries are therefore reflected in the Company's and subsidiary's investment accounts and earnings. The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions. 7 10 SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION

8 11 SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION

9 12 SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION

10 13 SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION

11 14 SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION

12 15 SUPPLEMENTAL CONSOLIDATING FINANCIAL INFORMATION

13 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion may contain "forward-looking" statements and are subject to risks and uncertainties that could cause actual results to differ significantly from expectations. In particular, statements contained in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" section which are not historical facts, including, but not limited to, statements regarding the anticipated adequacy of cash resources to meet the Company's working capital and capital expenditure requirements and statements regarding the anticipated proportion of revenues to be derived from a limited number of customers, may constitute forward-looking statements. Although the Company believes the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to have been correct. These risks and uncertainties include the substantial leverage of the Company, customer concentration and consolidation, dependence on licensed brands, a single site distribution facility, operating in international economies, unpredictability of discretionary consumer spending, competition, susceptibility to changing consumer preferences and obtaining full benefits from the new information system. The following discussion and analysis of financial condition and results from operations should be read in conjunction with the Consolidated Financial Statements and related Notes thereto included elsewhere. OVERVIEW The Company is a value-added distributor of optical products, costume jewelry, watches, clocks and other accessories primarily to mass merchandisers, chain drug stores/combo stores/supermarkets and variety stores in North America and the United Kingdom. As a value-added distributor, the Company provides customized store displays, merchandising management and a store-level field service force to replenish and restock displays, reorder product and attend to markdowns and allowances. Upon shipment to the customer, the Company estimates agreed-upon future allowances, returns and discounts, taking into account historical experience, and reflects revenue net of these estimates. When establishing or expanding a customer relationship, the Company generally enters into multi-year agreements for the supply of specified product lines to specific customer stores. The agreements typically do not contain required minimum sales volumes but may provide for termination penalties equal to the Company's unamortized cost of product displays provided to the customer. The Company believes its relationships with retailers are dependent upon its ability to efficiently utilize allocated floor space to generate satisfactory returns for its customers. To meet this end, the Company strives to consistently deliver competitively priced products and service programs, which provide retailers with attractive gross margins and inventory turnover rates. The Company has historically retained customers from year to year, although retailers may drop or add product lines supplied by the Company. Generally, customer loss has been attributable to such customer going out of business or being acquired by a company that does not carry the Company's product line or has prior relationships with a competitor of the Company. Certain segments of the retail industry, particularly mass merchandisers, variety stores, drugstores and supermarkets, are experiencing significant consolidation and in recent years many major retailers have experienced financial difficulties. These industry wide developments may have an impact on the Company's results of operations. In addition, many major retailers have sought to reduce inventory levels in order to reduce their operating cost, which has had a negative effect on the Company's results of operations. Net Sales. The Company currently offers optical products and costume jewelry, and during 2000 also offered small synthetic leather goods, watches, clocks and other accessories, generally at retail price points of $30 or less. The Company has discontinued offering small leather goods over the last fifteen months. The Company has also sold its Fantasma operation (see Note 7). Net sales of the Company's optical products accounted for approximately 79.9% and 70.0% of the Company's net sales for the three months ended March 31, 2001 and April 1, 2000, respectively. Net sales of the Company's costume jewelry accounted for approximately 19.4% and 27.2% of the Company's net sales for the three months ended March 31, 2001 and April 1, 2000, respectively, and the balance represented sales of synthetic leather goods, watches, clocks and other accessories. Cost of Goods Sold. The Company outsources manufacturing for all of its products, approximately 77.8% of which is sourced to manufacturers in Asia through its joint venture in Hong Kong, with the remainder outsourced to independent domestic manufacturers. Accordingly, the principal element comprising the Company's cost of goods sold is the price of manufactured goods purchased through the Company's joint venture or from independent manufacturers. The Company believes outsourcing manufacturing allows it 14 17 to reliably deliver competitively priced products to the retail market while retaining considerable flexibility in its cost structure. Also, included in Cost of Goods Sold are shipping costs that the Company does not separately bill to its customers. Operating Expenses. Operating expenses are comprised primarily of payroll and occupancy costs related to the Company's selling, general and administrative activities as well as depreciation and amortization. The Company incurs various costs in connection with the acquisition of new customers and new stores for existing customers, principally the cost of new product display fixtures and costs related to the purchase of the customer's existing inventory. The Company makes substantial investments in the design, production and installation of display fixtures in connection with establishing and maintaining customer relationships. The Company capitalizes the production cost of these display fixtures as long as it retains ownership of them. These costs are amortized to selling expense on a straight-line basis over their estimated useful life, which is one to three years. If the Company does not retain title to the displays, the display costs are expensed as shipped. During the three months ended April 1, 2000, the Company recognized a $2.5 million restructuring charge related to the accrual of severance payments due to three executives, which will be paid over a two-year period. The Company incurs direct and incremental costs in connection with the acquisition of certain new customers and new store locations from existing customers under multi-year agreements. The Company may also receive the previous vendor's merchandise from the customer in connection with these agreements. In these situations, the Company values this inventory at its fair market value, representing the lower of cost or net realizable value, and records that value as inventory. The Company sells this inventory through various liquidation channels. Except as provided below, the excess costs over the fair market value of the inventory received is charged to selling expense when incurred. The Company expensed customer acquisition costs of approximately $13,000 and $88,000 for the three months ended March 31, 2001 and April 1, 2000, respectively. The excess costs over the fair market value of the inventory received is capitalized as deferred costs and amortized over the agreement period if the Company enters into a minimum purchase agreement with the customer from which the estimated gross profits from future minimum sales during the term of the agreement are sufficient to recover the amount of the deferred costs. During the three months ended April 1, 2000, the Company did not capitalize any of these costs. The Company capitalized costs of approximately $40,000 during the three months ended March 31, 2001. Amortization expense for the three months ended March 31, 2001 and April 1, 2000 related to previously capitalized costs was approximately $85,000 and $320,000, respectively. Dividends and Accretion on Preferred Stock. The Company has 43,700 shares of Series A Redeemable Convertible Preferred Stock ("Series A Preferred Stock") outstanding, of which 34,200 were issued in May 1996 for gross proceeds of $18.0 million, and an additional 9,500 shares were issued for gross proceeds of $5.0 million in connection with the December 1996 acquisition of Foster Grant Group US and related companies. Beginning on June 30, 2002, shares of the Series A Preferred Stock are redeemable at the option of the holder for an amount equal to the original issue price plus accrued and unpaid dividends yielding a 10% compounded annual rate of return, provided, however, that the right to require redemption is suspended as long as any Restrictive Indebtedness (as defined in the Articles of Incorporation) is outstanding. Net loss applicable to common shareholders represents net loss less accretion of original issuance costs and cumulative dividends due on the Series A Preferred Stock. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Although EBITDA is not a measure of performance calculated in accordance with Generally Accepted Accounting Principles (GAAP), the Company believes that EBITDA is accepted as a generally recognized measure of performance in the distribution industry and provides an indicator of the earnings available to meet the Company's debt service obligations. EBITDA should not be considered in isolation or as a substitute for operating income, net income, net cash provided by operating activities or any other measure for determining the Company's operating performance or liquidity which is calculated in accordance with GAAP. EBITDA, excluding the restructuring charge of $2.5 million, was approximately $1.9 million and $6.0 million for the three months ended March 31, 2001 and April 1, 2000, respectively. The decrease of $4.1 million or 68%, excluding the restructuring charge, is principally due to the decrease in operating income, which relates principally to the decline in net sales. EBITDA, including the restructuring charge was $3.5 million for the three months ended April 1, 2000. Net loss before dividends and accretion on preferred stock was $3.7 million for the three months ended March 31, 2001 as compared to net income before dividends and accretion on preferred stock, excluding the restructuring charge, of $0.4 million for the three months ended April 1, 2000. Net loss before dividends and accretion on preferred stock, including the restructuring charge was $2.1 million for the three months ended April 1, 2000. 15 18 RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, the percentage relationship to net sales of certain items included in the Company's Consolidated Condensed Statements of Operations:

THREE MONTHS ENDED MARCH 31, 2001 COMPARED TO THREE MONTHS ENDED APRIL 1, 2000 Net Sales. Consolidated net sales were $30.1 million for the three months ended March 31, 2001 as compared to $42.5 million for the three months ended April 1, 2000, a decrease of $12.4 million. Sales of optical products decreased due to the timing of initial customer shipments for the 2000 sunglass rollout, which occurred during the first quarter of 2000 as compared to the initial orders being shipped in the fourth quarter of fiscal 2000 for the 2001 sunglass season. The decline is also attributable to planned reductions in jewelry, principally related to a change in the terms of service with a significant customer in the mass merchandiser channel, general softness in jewelry at retail across all channels and the planned de-emphasis on watches, clocks, and certain other accessory lines across all segments. Gross Profit. Gross profit was $12.1 million for the three months ended March 31, 2001 as compared to $18.9 million for the three months ended April 1, 2000. Gross profit as a percentage of net sales decrease to 40.3% for the three months ended March 31, 2001 from 44.6% for the three months ended April 1, 2000. The $6.8 million or 36.0% decrease is primarily due to the sales volume decline and a shift in mix to the variety channel where lower margin is realized. Operating Expenses. Operating expenses were $13.2 million for the three months ended March 31, 2001 as compared to $16.0 million, excluding the restructuring charge of $2.5 million for the three months ended April 1, 2000, a decrease of 17.6% or $2.8 million. Decreases occurred throughout the Company and represent continued attention to expense control. Expenses after the restructuring charge were $18.5 million for the three months ended April 1, 2000. The restructuring charge reflects an accrual for severance payments due to three executives, which will be paid over a two-year period through fiscal 2002. Interest Expense. Interest expense was $2.6 million for the three months ended March 31, 2001 and April 1, 2000. This resulted from higher average borrowings under the Company's credit facilities to fund operations completely offset by the interest savings generated by the bond repurchase during fiscal 2000. Income Tax. Income tax expense was $82,000 for the three months ended March 31, 2001. No income tax expense or benefit was recorded for the three months ended April 1, 2000. Net Income (Loss). As a result of the factors discussed above, net loss before dividends and accretion on preferred stock was $3.7 million for the three months ended March 31, 2001 as compared to net income before dividends and accretion on preferred stock, excluding the restructuring charge of $0.4 million for the three months ended April 1, 2000, a decrease of $4.1 million in earnings. Net loss before dividends and accretion on preferred stock, including the restructuring charge was $2.1 million for the three months ended April 1, 2000. 16 19 Net Loss Applicable to Common Shareholders. Net loss applicable to common shareholders was $4.5 million for the three months ended March 31, 2001 as compared to a loss, excluding the restructuring charge of $0.4 million for the three months ended April 1, 2000, an increase of $4.1 million. The increase is attributable to the $4.1 million decrease in earnings along with an increase of $76,000 in dividends and accretion on Series A Preferred Stock due to the compounding of accrued dividends. Net loss applicable to common shareholders after the restructuring charge was $2.9 million for the three months ended April 1, 2000. LIQUIDITY AND CAPITAL RESOURCES At March 31, 2001, the Company had cash and cash equivalents of $0.4 million and negative working capital of $3.9 million as compared to $0.6 million and $0.6 million, respectively, at December 30, 2000. The decline in cash and cash equivalents is due to the Company's enhanced focus on utilizing worldwide cash reserves to fund payments on its Senior Credit Facility. The decline in working capital was driven by continued focus on reductions in receivables and inventory, as well as the timing of the payment of interest on the Senior Notes on January 15, 2001. The payment was funded by the Senior Credit Facility. The Company generated $3.8 million of cash in operations during the three months ended March 31, 2001 compared to a use of $6.3 million during the three months ended April 1, 2000. The increase in cash resulted principally from continued collection efforts of accounts receivable and improved inventory management during the first quarter of fiscal 2001. The Company used $3.2 million in investing activities during the three months ended March 31, 2001 compared to a use of $2.7 million during the three months ended April 1, 2000. These investments were primarily related to the purchase of display fixtures used in the merchandising of both optical and jewelry products and represent normal purchases. The Company used $0.7 million from financing activities during the three months ended March 31, 2001 compared to generating $7.4 million during the three months ended April 1, 2000. The decrease in cash from financing activities is primarily due to an increase in cash provided by operating activities, which was utilized to pay down the revolving note payable. The Company has 43,700 shares of Series A Preferred Stock that has a redemption value at March 31, 2001 of $36.0 million. Shares of Series A Preferred Stock are convertible into Common Stock at a rate of 10 for 1, adjustable for certain dilutive events. Conversion is at the option of the shareholder, but is automatic upon the consummation of a qualified public offering. The holders of Series A Preferred Stock have the right to require redemption for cash for any unconverted shares, beginning June 30, 2002, provided, however, that the right to require redemption is suspended as long as any Restrictive Indebtedness is outstanding. The Notes constitute Restrictive Indebtedness. The redemption price of the Series A Preferred Stock is an amount equal to the original issue price, $526.32 per share, plus any accrued and unpaid dividends yielding a 10% compounded annual rate of return. In connection with the purchase of Foster Grant US, the Company's wholly owned subsidiary, Foster Grant Holdings, Inc. (FG Holdings) issued 100 shares of FG Preferred Stock, which were redeemable for $1.0 million on February 28, 2000. The $1.0 million was paid on April 3, 2000. The former holder of the FG Preferred Stock is entitled to receive an additional payment of between $2.5 million and $3.0 million, depending upon transaction value, in the event of an initial public offering, merger or similar transaction, or private placement of securities representing more than 50% of the Company's capital stock, at a specified valuation. The Company has substantial indebtedness and significant debt service obligations. As of March 31, 2001, the Company had total indebtedness, including borrowings under the Senior Credit Facility, in the aggregate principal amount of $85.7 million. The Company had current liabilities of approximately $65.5 million. In addition, the Company has significant annual obligations that include interest on the Notes of approximately $5.6 million, minimum royalty obligations over the next two years of approximately $2.9 million and minimum payments under its operating leases of approximately $417,000. The Indenture permits the Company to incur additional indebtedness, including secured indebtedness, subject to certain limitations. The Company has up to $3.4 million available for borrowings under the Senior Credit Facility as of March 31, 2001. Interest rates on the revolving loans under the Senior Credit Facility are based, at the Company's option, on the Base Rate (as defined) or LIBOR plus an applicable margin. The Senior Credit Facility contains certain restrictions and limitations, including financial covenants that require the Company to maintain and achieve certain levels of financial performance and limit the payment of cash dividends and similar restricted payments. As of March 31, 2001, the Company was not in compliance of certain financial covenants. On May 14, 2001, the Company entered into a sixth amendment to the Senior Credit Facility which modified the financial covenants and waived non-compliance with the prior covenants. 17 20 The Company's ability to make scheduled payments of principal, or to pay the interest on, or to refinance, its indebtedness (including the Notes), or to fund planned capital expenditures will depend on its future performance, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond its control. Based upon the current level of operations and anticipated cost savings and revenue growth, the Company believes that cash flow from operations and available cash, together with available borrowings under the Senior Credit Facility, will be adequate to meet the Company's future liquidity needs for at least the next several years. The Company may, however, need to refinance all or a portion of the principal of the Notes on or prior to maturity. There can be no assurance that the Company's business will generate sufficient cash flow from operations, that anticipated cost savings and revenue growth will be realized or that future borrowings will be available under the Senior Credit Facility in an amount sufficient to enable the Company to service its indebtedness, including the Notes, or to fund its other liquidity needs. In addition, there can be no assurance that the Company will be able to effect any such refinancing on commercially reasonable terms or at all. SEASONALITY AND QUARTERLY INFORMATION Significant portions of the Company's business are seasonal. Sunglasses are shipped primarily during the fourth quarter of the fiscal year as retailers build inventory for the spring and summer selling seasons, while costume jewelry and other accessories are shipped primarily during the second half of the fiscal year as retailers build inventory for the holiday season. Reading glasses sales are generally uniform throughout the year. As a result of these shipping trends, the Company's working capital requirements grow throughout the first half of the year to fund purchases and accounts receivable. In the second half of the year, the Company's working capital requirements decreases as accounts receivables are collected. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The following discussion about the Company's market risk disclosures includes forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. The Company is exposed to market risk related to changes in interest rates and foreign currency exchange rates. The Company does not use derivative financial instruments for speculative or trading purposes. Interest Rate Risk. The Company is exposed to market risk from changes in interest rates primarily through its borrowing activities. In addition, the Company's ability to finance future acquisition transactions may be impacted if the Company is unable to obtain appropriate financing at acceptable interest rates. Foreign Currency Risk. The Company's results of operations are affected by fluctuations in the value of the U.S. dollar as compared to the value of currencies in foreign markets primarily related to changes in the British Pound, the Canadian Dollar, the Mexican Peso, the Euro Dollar and the Hong Kong Dollar. During the three months ended March 31, 2001, the net impact of foreign currency changes was not material to the Company's financial condition or results of operations. The Company manages its exposure to foreign currency exchange risk by trying to minimize the Company's net investment in its foreign subsidiaries. The Company generally does not enter into derivative financial instruments to manage foreign currency exposure. The Company's operations in Europe are not significant and, therefore, the Company has not been materially impacted by the fluctuations in the Euro exchange. 18 21 AAI. FOSTERGRANT, INC. AND SUBSIDIARIES PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 10.1.6 Sixth Amendment to Second Amended and Restated Financing and Security Agreement dated as of May 14, 2001. (b) Report on Form 8-K The registrant filed no reports on Form 8-K during the quarter ended March 31, 2001. 19 22 AAI. FOSTERGRANT, INC. AND SUBSIDIARIES SIGNATURES 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 hereunto duly authorized. AAi.FosterGrant, Inc. (Registrant) Dated: May 15, 2001 /s/ Michael F. Cronin ---------------------------------------- Michael F. Cronin Chairman of the Board Dated: May 15, 2001 /s/ John R. Ranelli ---------------------------------------- John R. Ranelli Director, President, and Chief Executive Officer (Principal Executive Officer) Dated: May 15, 2001 /s/ Brian J. Lagarto ---------------------------------------- Brian J. Lagarto Chief Financial Officer (Principal Financial Officer) 20

AAI FOSTERGRANT INC 10-Q