10-Q 1 d10q.txt FORM 10-Q FOR PERIOD ENDING 04/28/2002 =============================================================================== 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 quarterly period ended April 28, 2002 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 Number 333-73107 ST. JOHN KNITS INTERNATIONAL, INCORPORATED (Exact Name of Registrant as Specified in its Charter) Delaware 52-2061057 (State or Other Jurisdiction of (I.R.S. Employer Identification Number) Incorporation or Organization) 17622 Armstrong Avenue, Irvine, California 92614 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (949) 863-1171 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 ____ --- The number of outstanding shares of registrant's Common Stock, par value $0.01 per share, was 6,546,240 shares as of June 11, 2002. =============================================================================== PART I. FINANCIAL INFORMATION Item 1. Financial Statements ST. JOHN KNITS INTERNATIONAL, INCORPORATED CONSOLIDATED BALANCE SHEETS

See accompanying notes. 2 ST. JOHN KNITS INTERNATIONAL, INCORPORATED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

See accompanying notes. 3 ST. JOHN KNITS INTERNATIONAL, INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS

4 ST. JOHN KNITS INTERNATIONAL, INCORPORATED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)

See accompanying notes. 5 ST. JOHN KNITS INTERNATIONAL, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) 1. Basis of Presentation and Company Operations The accompanying unaudited consolidated financial statements of St. John Knits International, Incorporated ("SJKI") and its subsidiaries, including St. John Knits, Inc. ("St. John"), reflect all adjustments (which include only normal recurring adjustments) considered necessary to present fairly the financial position, results of operations and cash flows for the periods presented. SJKI and its subsidiaries are collectively referred to herein as "the Company." It is suggested that the accompanying unaudited consolidated financial statements and notes thereto be read in conjunction with the financial statements and notes included in the Company's Annual Report on Form 10-K for the year ended October 28, 2001 as filed with the Securities and Exchange Commission on January 28, 2002. The results of operations for the periods presented are not necessarily indicative of the operating results that may be expected for the year ending November 3, 2002. Company Operations The Company is a leading designer, manufacturer and marketer of women's clothing and accessories. The Company's products are distributed primarily through specialty retailers and Company owned retail boutiques and outlet stores in the United States and internationally. The Company also operates two home furnishing stores and one home furnishing outlet store under the name St. John Home. All intercompany and interdivisional transactions and accounts have been eliminated. Definition of Fiscal Year The Company utilizes a 52-53 week fiscal year whereby the fiscal year ends on the Sunday nearest to October 31. The quarters also end on the Sunday nearest the end of the quarter, which accordingly were April 28, 2002 and April 29, 2001. 2. Dividends SJKI has not paid any cash dividends to its common stockholders since the completion of the mergers in July 1999. SJKI does not anticipate the payment of any cash dividends on its common stock in the future. 3. Earnings Per Common Share Basic earnings per common share is computed by dividing income allocated to common stockholders by the weighted average number of common shares outstanding, excluding the dilutive effect of common stock equivalents, including stock options. Preferred stock dividends are deducted from net income to arrive at income allocated to common stockholders. Diluted earnings per common share includes all dilutive items and is calculated based upon the treasury stock method, which assumes that all dilutive securities were exercised and that the proceeds received were applied to repurchase outstanding shares at the average market price during the period. 6 ST. JOHN KNITS INTERNATIONAL, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (unaudited) The following is a reconciliation of the Company's net income and weighted average shares outstanding for the purpose of calculating basic and diluted earnings per common share for all periods:

4. Inventories Inventories consist of the following: April 28, October 28, 2002 2001 ----------- ----------- (unaudited) Raw materials ........................... $12,383,407 $13,011,735 Work-in-process ......................... 7,355,020 8,184,806 Finished products ....................... 27,815,970 31,301,156 ----------- ----------- $47,554,397 $52,497,697 =========== =========== 5. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 addresses financial accounting and reporting for business combinations and is effective for all business combinations after June 30, 2001. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets and is effective for fiscal years beginning after December 15, 2001. The adoption of these standards is not expected to have a material impact on the Company's financial position or results of operations. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for the disposal of a segment of a business (as previously defined in that Opinion). The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001, with early application encouraged, 7 ST. JOHN KNITS INTERNATIONAL, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (unaudited) and generally are to be applied prospectively. The adoption of this standard is not expected to have a material impact on the Company's financial position or results of operations. In April 2001, Emerging Issues Task Force ("EITF") No. 00-25, "Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor's Products" was issued. EITF No. 00-25 governs the accounting for consideration from a vendor to a reseller of the vendor's products and was adopted by the Company in the fourth quarter of fiscal 2001. The adoption of this EITF did not have a material impact on the Company's financial position or results of operations. 6. Segment Information The Company has two reportable business segments, wholesale and retail sales. For the second quarter and first six months of fiscal 2002, retail sales were generated through the Company's 26 St. John boutiques, 10 St. John outlet stores, three St. John Home stores and one St. John Home outlet store. Management evaluates segment performance based primarily on revenue and earnings from operations. Segment information is summarized as follows for the periods indicated (in 000's): Wholesale Retail Eliminations Total --------- ------ ------------ ----- Second Quarter Fiscal 2002 Net sales ......................... $ 71,623 $38,335 $ (17,679) $ 92,279 Segment operating income .......... $ 13,740 $ 4,876 $ (773) $ 17,843 Second Quarter Fiscal 2001 Net sales ......................... $ 80,212 $33,343 $ (16,495) $ 97,060 Segment operating income .......... $ 17,685 $ 2,993 $ (542) $ 20,136 First Six Months Fiscal 2002 Net sales ......................... $144,691 $75,281 $ (39,728) $180,244 Segment operating income .......... $ 29,602 $ 6,235 $ (2,386) $ 33,451 First Six Months Fiscal 2001 Net sales ......................... $163,812 $66,213 $ (31,783) $198,242 Segment operating income .......... $ 40,095 $ 4,505 $ (625) $ 43,975 7. Subsequent Event On May 17, 2002, Vestar and the Gray family entered into an agreement to sell their interest in the Company's mandatorily redeemable preferred stock to a third party. In connection with such sale, the terms of the preferred stock were amended to provide for the exchange of the securities, plus any accrued dividends, for senior subordinated unsecured notes bearing interest at a rate of 15.25%. The Company has notified the new holder of its intent to cause such exchange effective July 2, 2002, which will result in the issuance of approximately $38.0 million in subordinated notes. The Company will have the option to call the notes at par after six months and before 18 months from the transaction date. After 18 months, the Company's call option will expire and the securities will be non-callable until July 8 ST. JOHN KNITS INTERNATIONAL, INCORPORATED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (unaudited) 7, 2004. At that date, the securities will have a call premium starting at 7.625% and decreasing ratably to zero at maturity on July 7, 2009. 8. Supplemental Condensed Consolidated Financial Information The Company's payment obligations under its senior subordinated notes are guaranteed by certain of the Company's wholly owned subsidiaries (the "Guarantor Subsidiaries"). Such guarantees are full, unconditional and joint and several. Except for restrictions under applicable law, there are no material restrictions on distributions from the Guarantor Subsidiaries to SJKI. Separate financial statements of the Guarantor Subsidiaries are not presented because the Company's management has determined that they would not be material to investors. The following supplemental financial information sets forth, on an unconsolidated basis, balance sheet, statement of income, and statement of cash flow information for the Parent Company (consisting of SJKI and St. John), for the Guarantor Subsidiaries and for the Company's other subsidiaries (the "Non-Guarantor Subsidiaries"). The supplemental financial information reflects the investments of the Parent Company in the Guarantor Subsidiaries and Non-Guarantor Subsidiaries using the equity method of accounting. The supplemental financial information is presented for the periods as of April 28, 2002 and October 28, 2001, and for the 13 and 26 weeks ended April 28, 2002 and April 29, 2001. 9 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET APRIL 28, 2002 (UNAUDITED)

(1) Inventories are shown at cost for all entities 10 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING BALANCE SHEET OCTOBER 28, 2001

(1) Inventories are shown at cost for all entities. 11 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF INCOME THIRTEEN WEEKS ENDED APRIL 28, 2002 (UNAUDITED)

12 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF INCOME THIRTEEN WEEKS ENDED APRIL 29, 2001 (UNAUDITED)

13 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF INCOME TWENTY-SIX WEEKS ENDED APRIL 28, 2002 (UNAUDITED)

14 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF INCOME TWENTY-SIX WEEKS ENDED APRIL 29, 2001 (UNAUDITED)

15 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS TWENTY-SIX WEEKS ENDED APRIL 28, 2002 (UNAUDITED)

16 ST. JOHN KNITS INTERNATIONAL, INCORPORATED SUPPLEMENTAL CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS TWENTY-SIX WEEKS ENDED APRIL 29, 2001 (UNAUDITED)

17 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations The following table is derived from the Company's Consolidated Statements of Income and sets forth, for the periods indicated, the results of operations as a percentage of net sales:

18 Certain Critical Accounting Policies The Company's consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States. As such, the Company is required to make estimates and assumptions that affect the reported amounts of assets and liabilities at the balance sheet dates and the reported amounts of revenue and expense during the reporting periods. Actual results could significantly differ from such estimates. The Company believes that the following accounting policies are among the most critical because they involve significant judgements and uncertainties and could potentially result in materially different results under different assumptions and conditions. Inventories Inventories are stated at the lower of the cost to purchase and/or manufacture the inventory or the current estimated market value (lower of cost or market). The Company regularly reviews its inventory quantities on hand and records a provision for excess and obsolete inventory based primarily on the Company's estimated forecast of product demand and production requirements. Any significant adverse change in the anticipated demand for the Company's products could cause the Company to revise its estimate of excess and obsolete inventory. Wholesale Markdowns The Company has agreements with its major wholesale customers to reimburse them for markdowns which exceed an agreed upon level. The Company records an estimate of its liability under these agreements at the time of sale, based upon historical experience. These estimates are based in part on projected sales and markdowns for these customers into the future. While historical experience has been within management's expectations, any significant variation from the projected sales or markdowns could cause the Company to change its estimates. Accounts Receivable The Company performs ongoing credit evaluations of its wholesale customers and adjusts credit limits based upon payment history and the customer's current financial status. The Company continuously monitors its customer payments and maintains a provision for estimated credit losses based upon the Company's historical experience and any specific customer collection issues that have been identified. The Company's accounts receivable are concentrated in the apparel industry, primarily with its three major customers. The risk of collection is concentrated within this industry and with these specific customers. As a result of this concentration, a change in the credit worthiness of the companies within the apparel industry could cause the Company to revise its estimate of credit losses. Insurance Program Beginning on January 1, 2002, the Company became partially self-insured for its workers' compensation insurance coverage. Under this insurance program the Company is liable for a deductible of $500,000 for each individual claim. The Company records a liability for the estimated cost of claims both reported and incurred but not reported. The estimated costs include the estimated future cost of all open claims. The Company will continue to adjust the estimates as the actual experience dictates. 19 Results of Operations Second Quarter Fiscal 2002 Compared to Second Quarter Fiscal 2001 Net sales for the second quarter of fiscal 2002 decreased by $4.8 million, or 4.9% as compared to the second quarter of fiscal 2001. This decrease was principally attributable to a decrease in sales to domestic wholesale customers of approximately $10.1 million, due in part to their reduced inventory levels from the same period of the prior year. This decrease was partially offset by an increase in sales by Company-owned retail stores of approximately $5.0 million, due in part to the addition of three retail boutiques since the beginning of the second quarter of fiscal 2001. Sales for Company owned retail boutiques open at least one year increased 9.9% over the second quarter of fiscal 2001. Gross profit for the second quarter of fiscal 2002 decreased by $3.5 million, or 6.1% as compared with the second quarter of fiscal 2001, and decreased as a percentage of net sales to 57.5% from 58.2%. This decrease in the gross profit margin was primarily the result of a decrease in the gross profit margin for the Knit product line, due to a reduction in the number of units being manufactured and sold without a corresponding decrease in the production costs. The decrease was partially offset by an increase in sales by Company owned retail boutiques, which on a consolidated basis have a higher gross profit margin than sales to wholesale customers. Selling, general and administrative expenses for the second quarter of fiscal 2002 decreased by $1.2 million, or 3.2% as compared to the second quarter of fiscal 2001, and increased as a percentage of net sales to 38.2% from 37.5%. Selling, general and administrative expenses decreased during the period, primarily due to a decrease in advertising and promotion expenses of approximately $0.9 million, combined with a decrease in severance expenses of approximately $1.7 million, due to non-recurring expenses which were recorded during the second quarter of fiscal 2001. These decreases were partially offset by an increase in selling, general and administrative expenses associated with the retail division of approximately $1.1 million, resulting from the expansion of the Company's retail operations. Selling, general and administrative expenses increased as a percentage of net sales primarily due to the decrease in sales without a corresponding decrease in expenses due to the Company's decision to maintain its infrastructure to allow for a quick response to an increase in demand. Operating income for the second quarter of fiscal 2002 decreased by $2.3 million, or 11.4% as compared to the second quarter of fiscal 2001. Operating income as percentage of net sales decreased to 19.3% from 20.7% during the same period. This decrease in operating income as a percentage of net sales was due to a decrease in the gross profit margin and an increase in selling, general and administrative expenses as a percentage of net sales. Interest expense for the second quarter of fiscal 2002 decreased by $2.3 million, or 30.5% from the second quarter of fiscal 2001. This decrease was primarily due a reduction in interest rates between the periods and a reduction in the debt balance since the end of the first quarter of fiscal 2001. First Six Months Fiscal 2002 Compared to First Six Months Fiscal 2001 Net sales for the first six months of fiscal 2002 decreased by $18.0 million, or 9.1% as compared to the first six months of fiscal 2001. This decrease was principally attributable to a decrease in sales to domestic wholesale customers of approximately $25.2 million, due in part to their reduced inventory levels from the same period of the prior year, combined with an increase in markdowns related to the Company's wholesale sales of $1.5 million. This decrease was partially offset by an increase in sales by Company-owned retail stores of approximately $9.1 million, due in part to the addition of four retail 20 boutiques since the beginning of fiscal 2001. Sales for Company owned retail boutiques open at least one year increased 8.5% over the first six months of fiscal 2001. Gross profit for the first six months of fiscal 2002 decreased by $10.7 million, or 9.4% as compared with the first six months of fiscal 2001, and decreased slightly as a percentage of net sales to 56.8% from 57.1%. This decrease in the gross profit margin was primarily the result of a decrease in the gross profit margin for the Knit product line, due to a reduction in the number of units being manufactured and sold without a corresponding decrease in the production costs. The decrease was partially offset by an increase in sales by Company owned retail boutiques, which on a consolidated basis have a higher gross profit margin than sales to wholesale customers. Selling, general and administrative expenses for the first six months of fiscal 2002 remained constant with the expenses reported for the first six months of fiscal 2001, and increased as a percentage of net sales to 38.3% from 34.9%. Selling, general and administrative expenses decreased during the period, primarily due to a decrease in advertising and promotion expenses of approximately $1.6 million, combined with a decrease in severance expenses of approximately $1.7 million, due to non-recurring expenses which were recorded during the second quarter of fiscal 2001. These decreases were offset by an increase in selling, general and administrative expenses associated with the retail division of approximately $2.9 million, resulting from the expansion of the Company's retail operations and increases in various other expense categories. Selling, general and administrative expenses increased as a percentage of net sales primarily due to a decrease in net sales without a corresponding decrease in the selling, general and administrative expenses due to the Company's decision to maintain its infrastructure to allow for a quick response to an increase in demand. Operating income for the first six months of fiscal 2002 decreased by $10.5 million, or 23.9% as compared to the first six months of fiscal 2001. Operating income as percentage of net sales decreased to 18.5% from 22.2% during the same period. This decrease in operating income as a percentage of net sales was primarily due to an increase in selling, general and administrative expenses as a percentage of net sales. Interest expense for the first six months of fiscal 2002 decreased by $4.4 million, or 28.5% from the first six months of fiscal 2001. This decrease was primarily due a reduction in interest rates between the periods and a reduction in the debt balance since the end of fiscal 2001. Liquidity and Capital Resources The Company's primary cash requirements are to fund payments required to service the Company's debt, to fund the Company's working capital needs, primarily inventory and accounts receivable, and for the purchase of property and equipment. During the first six months of fiscal 2002, cash provided by operating activities was $35.3 million. Cash provided by operating activities was primarily generated by net income, a decrease in accounts receivable and inventories and an increase in income taxes payable while cash used in operating activities was primarily used to fund a decrease in accounts payable. Cash used in investing activities was $5.8 million during the first six months of fiscal 2002. The principal use of cash in investing activities was for the construction of leasehold improvements for scheduled new boutiques and upgrades to the Company's computer systems. Cash used in financing activities was $17.7 million during the first six months of fiscal 2002, including prepayments made on the Company's senior secured debt of $15.0 million. These prepayments included a $6.8 million payment that was required under the terms of the credit agreement based on the calculation of the Company's excess cash flow. 21 As of April 28, 2002, the Company had approximately $69.0 million in working capital and $37.7 million in cash and marketable securities. The Company's principal source of liquidity is internally generated funds. The Company also has a $25.0 million revolving commitment from a bank ("Revolving Commitment") which expires on July 31, 2005. The Revolving Commitment is secured and borrowings thereunder bear interest at the Company's choice of the bank's borrowing rate plus 1.0% (4.75% at April 28, 2002) or a Eurodollar rate plus 2.0%. The availability of funds under the Revolving Commitment is subject to the Company's continued compliance with certain covenants, including a covenant that sets the maximum amount the Company can spend annually on the acquisition of fixed or capital assets, and certain financial covenants, including a maximum leverage ratio, a minimum fixed charge coverage ratio and a minimum interest expense coverage ratio. As of April 28, 2002, the Company was in compliance with all covenants and no amounts were outstanding under the Revolving Commitment. The Company currently has $6.0 million of letters of credit outstanding which reduces the amount available under the Revolving Commitment by a corresponding amount. The Company invests its excess cash in a money market fund. Total debt outstanding decreased $17.6 million to $234.7 million during the six months ended April 28, 2002. The Company's outstanding debt is comprised of bank borrowings of $135.7 million and senior subordinated notes of $99.0 million. The Company's primary ongoing cash requirements will be for debt service and capital expenditures. The Company's debt service requirements consist primarily of principal and interest payments on bank borrowings and interest on its senior subordinated notes. The Company believes it will be able to finance its debt service and capital expenditure requirements for the foreseeable future with internally generated funds and funds available under the Company's revolving credit facility. However, the Company's ability to fund its capital investment requirements, interest and principal payment obligations and working capital requirements and to comply with all of the financial covenants under its debt agreements depends on its future operating performance and cash flow, which in turn are subject to prevailing economic conditions and to financial, business and other factors, some of which are beyond the Company's control. The table below details the Company's obligations and commitments under contracts and lease agreements in effect as of April 28, 2002:

(A) The amounts shown in this column reflect the amounts to be paid during the remainder of the fiscal year. In addition to payments under the above contractual obligations, the Company anticipates purchasing property and equipment of approximately $12.5 million during the remainder of fiscal 2002. The estimated $12.5 million will be used principally for (i) the construction of leasehold improvements for three new retail boutiques located in San Jose, California, Orlando, Florida and Short Hills, New Jersey, (ii) the purchase of electronic knitting machines, (iii) the construction of 22 leasehold improvements for a relocated boutique in Atlanta, Georgia and (iv) upgrades to the Company's computer systems. SJKI must rely on distributions, loans and other intercompany cash flows from its affiliates and subsidiaries to generate the funds necessary to satisfy the repayment of its outstanding loans. Except for restrictions under applicable law, there are no material restrictions on distributions to the Company from the Company's wholly owned subsidiaries that have guaranteed the Company's payment obligations under its senior subordinated notes. See Note 8 to the Company's unaudited consolidated financial statements contained herein. The Company may repurchase, from time to time, a portion of its 12.5% Senior Subordinated Notes, subject to market conditions and other factors. No assurance can be given as to whether or when or at what prices such repurchases will occur. In addition, the Company may be required to repurchase a portion of the common stock beneficially owned by the Gray family. Any such repurchases would be limited by the restrictions of the agreements under the credit facilities and senior subordinated notes. SJKI has not paid any cash dividends since the completion of the mergers in July 1999. SJKI's ability to pay dividends is restricted by the terms of its senior secured credit facilities and senior subordinated note indenture. SJKI does not anticipate the payment of any cash dividends on its common stock in the future. The Company's EBITDA (EBITDA generally represents net income excluding the effects of interest expense, income taxes, depreciation and a majority of the items included in other income) as defined in its credit agreement for its senior secured credit facilities was approximately $41.0 million and $51.6 million for the first six months of fiscal 2002 and 2001, respectively, and $21.6 and $23.8 million for the second quarter of fiscal 2002 and 2001, respectively. EBITDA is not a defined term under Generally Accepted Accounting Principles ("GAAP") and is not an alternative to operating income or cash flow from operations as determined under GAAP. The Company believes that EBITDA provides additional information for determining its ability to meet future debt service requirements; however, EBITDA does not reflect cash available to fund cash requirements and should not be construed as an indication of the Company's operating performance or as a measure of liquidity. Credit Facilities In order to finance a portion of the cash consideration paid pursuant to the mergers, the Company entered into a credit agreement with a group of financial institutions, which provides for an aggregate principal amount of loans totaling $215 million. The credit agreement consists of three facilities: (i) tranche A facility totaling $75 million, (ii) tranche B facility totaling $115 million and (iii) the revolving credit facility totaling $25 million which matures July 31, 2005. Borrowings under the tranche A facility and the revolving credit facility bear interest at a floating rate, which is based upon the leverage ratio of the Company, but cannot exceed the banks' borrowing rate plus 2.0% or LIBOR plus 3.0%. Borrowings under the tranche B facility bear interest at a floating rate, which is also based upon the leverage ratio of the Company, but cannot exceed the banks' borrowing rate plus 2.5% or LIBOR plus 3.5%. In addition, the Company is required to pay a commitment fee on the unused portion of the revolving credit facility of 0.5% per year. 23 Borrowings under the tranche A facility began to mature quarterly on October 31, 1999, while borrowings under the tranche B facility began to mature quarterly on October 31, 2000. The credit agreement permits the Company to prepay loans and to permanently reduce revolving credit commitments, in whole or in part, at any time. In addition, the Company is required to make mandatory prepayments of tranche A and B facilities, subject to certain exceptions, in amounts equal to (i) 50% of excess cash flow (as defined in the credit agreement); and (ii) 100% of the net cash proceeds of certain dispositions of assets or issuances of debt or equity of the Company or any of its subsidiaries (in each case, subject to certain exceptions and subject to a reduction to zero based upon the Company's financial performance). The obligations of the Company under the credit agreement are guaranteed by each domestic subsidiary of the Company, including St. John, and to the extent no adverse tax consequences would result from such guarantees, each foreign subsidiary of the Company. The credit agreement and the related guarantees are secured by (i) a pledge of 100% of the capital stock of each domestic subsidiary of the Company, including St. John, and 65% of each foreign subsidiary of the Company and (ii) a security interest in, and mortgage on, substantially all the assets of the Company and each domestic subsidiary of the Company, including St. John, and to the extent no adverse tax consequences would result therefrom, each foreign subsidiary of the Company. The credit agreement requires the Company to comply with specified financial ratios, including a minimum interest coverage ratio, a maximum leverage ratio and a minimum fixed charge coverage ratio. The credit agreement also contains additional covenants that, among other things, restrict the ability of the Company to dispose of assets, incur additional indebtedness, pay dividends, create liens on assets, make investments, loans or advances and engage in mergers or consolidations. The credit agreement prohibits the Company from declaring or paying any dividends or making any payments with respect to the Company's senior subordinated notes if it fails to perform its obligations under, or fails to meet the conditions of, the credit agreement or if payment creates a default under the credit agreement. The credit agreement contains customary events of default. Senior Subordinated Notes In addition to the credit facilities described above, the Company sold $100 million of senior subordinated notes (the "notes") to help finance the mergers. The notes are unsecured and mature on July 1, 2009. The notes bear interest at a rate of 12.5% per year and were issued at 98.616% of the actual face value. Interest on the notes is payable semiannually to the holders of record. The notes are subject to redemption by the Company on or after July 1, 2004 at a premium starting at 6.25% and decreasing to zero at July 1, 2008. In addition, on or before July 1, 2002, the Company may redeem up to 35% of the outstanding notes with the net cash proceeds of certain equity offerings at a premium of 12.5%. The indenture governing the notes limits, among other things, the payment of dividends, the incurrence of additional indebtedness and other restricted payments. The indenture contains customary events of default. Redeemable Common Stock In connection with the mergers, SJKI has entered into a stockholders' agreement with Vestar/Gray Investors, Vestar and the Grays, which states, among other things, that prior to a public offering of SJKI common stock, if Bob Gray ceases to serve as Chairman or Chief Executive Officer of St. John or SJKI or if the employment with SJKI of Marie Gray or Kelly Gray ceases for any reason, then he or she will have the right to require SJKI to purchase the shares of SJKI common stock beneficially owned by them, at fair value, up to a maximum of $5 million of such common stock for all the Grays during 24 any 12-month period. If any of the Grays are terminated without "cause" or resigns for "good reason," as these terms are defined in their employment agreements with the Company, then he or she will have the right to require SJKI to purchase the shares of SJKI common stock beneficially owned by them, up to a maximum of 25% of the total shares held by such terminated or resigning Gray employee during any 12-month period. This agreement may be limited by the terms of the agreements related to the credit facilities and the notes. Mandatorily Redeemable Preferred Stock In order to finance a portion of the cash consideration paid in the mergers, SJKI issued 250,000 shares of 15.25% Mandatorily Redeemable Preferred Stock due 2010 (the "preferred stock") to Vestar/SJK Investors LLC. The liquidation preference of the preferred stock is $100 per share. The preferred stock ranks junior in right of payment to all liabilities and obligations (whether or not for borrowed money) of SJKI (other than common stock of SJKI and any preferred stock of SJKI which by its terms is on parity with or junior to the preferred stock). Holders of the preferred stock are entitled to receive, when, and if declared by the Board of Directors of SJKI, out of funds legally available therefor, dividends on the preferred stock, at an annual rate equal to 15.25%, provided that if dividends are not paid on a dividend payment date, dividends will continue to accrue on unpaid dividends. Dividends on the preferred stock may only be paid in cash if permitted under the terms of the Company's senior secured credit facilities, indenture and other contractual arrangements. Dividends accrue from the date of issuance and are payable semi-annually in arrears on January 1 and July 1 of each year, commencing on January 1, 2000. If permitted under the terms of the Company's senior secured credit facilities, the indenture and other contractual arrangements, the preferred stock may be redeemed at any time, in whole or in part, at the option of SJKI at specified redemption prices. On July 1, 2010, SJKI is required to redeem (subject to contractual and other restrictions with respect thereto and to the legal availability of funds therefor) all outstanding shares of preferred stock at a price equal to the liquidation value thereof plus all accumulated dividends to the date of redemption. SJKI may, at its option, exchange all, but not less than all, of the shares of the then outstanding preferred stock for debentures of SJKI in a principal amount equal to the liquidation value of the preferred stock plus accumulated dividends. The exchange debentures will bear interest at 15.25% per year, have a final stated maturity of July 1, 2010, have optional redemption provisions comparable to the preferred stock and will have customary covenants and events of default. SJKI may not cause the exchange of the preferred stock for debentures unless permitted under the terms of the Company's senior secured credit facilities, the indenture and other contractual arrangements. On May 17, 2002, Vestar and the Gray family entered into an agreement to sell their interest in the Company's mandatorily redeemable preferred stock to a third party. In connection with such sale, the terms of the preferred stock were amended to provide for the exchange of the securities, plus any accrued dividends, for senior subordinated unsecured notes bearing interest at a rate of 15.25%. The Company has notified the new holder of its intent to cause such exchange effective July 2, 2002, which will result in the issuance of approximately $38.0 million in subordinated notes. The Company will have the option to call the notes at par after six months and before 18 months from the transaction date. After 18 months, the Company's call option will expire and the securities will be non-callable until July 7, 2004. At that date, the securities will have a call premium starting at 7.625% and decreasing ratably to zero at maturity on July 7, 2009. Inflation The Company does not believe that inflation had a material impact on the sales reported for the second quarter or first six months of fiscal 2002. 25 Forward Looking Statements This Quarterly Report on Form 10-Q contains certain statements which describe the Company's beliefs concerning future business conditions and the outlook for the Company based on currently available information. Wherever possible the Company has identified these "forward looking" statements (as defined in Section 21E of the Securities Exchange Act of 1934) by words such as "anticipates," "believes," "estimates," "expects" and other similar expressions. The forward looking statements and associated risks set forth herein may include or relate to: (i) the Company's anticipated purchases of property and equipment during the remainder of fiscal 2002, (ii) the Company's belief that it will be able to fund its working capital and capital expenditure requirements with internally generated funds and the use of its revolving credit facility and (iii) the Company's anticipation that it will not pay cash dividends on its common stock in the future. These forward looking statements are subject to risks, uncertainties and other factors which could cause the Company's actual results, performance or achievements to differ materially from those expressed in, or implied by, these statements. These risks, uncertainties and other factors include, but are not limited to, the following: (i) the financial strength of the retail industry and the level of consumer spending for apparel and accessories, (ii) the Company's ability to develop, market and sell its products, (iii) increased competition from other manufacturers and retailers of women's clothing and accessories, (iv) general economic conditions and (v) the inability of the Company to meet the financial covenants under its senior secured credit facilities and subordinated note indenture. The potential adverse impact on the Company of these and other risks is discussed in more detail in the Company's Form 10-K for the year ended October 28, 2001 and the risk factors described therein are incorporated herein by reference. 26 Item 3. Quantitative and Qualitative Disclosures About Market Risk The Company has exposure to fluctuations in foreign currency exchange rates for the revenues derived from sales to its foreign customers denominated in foreign currencies. In order to reduce the effects of such fluctuations, under established risk management practices, the Company enters into forward contracts. These contractual arrangements are placed with a major financial institution. The Company does not hold derivative financial instruments for trading. The primary business objective of this hedging program is to secure the anticipated profit on sales denominated in foreign currencies. Forward contracts are usually entered into at the time the Company prices its products. The Company's primary exposure to foreign currency exchange rate fluctuation is on the Euro and the yen. At April 28, 2002, the Company had contracts maturing through October 31, 2002 to sell 2.4 million Euros at a rate of 0.88 U.S. dollars to the Euro and contracts maturing through January 31, 2003 to sell 234 million yen at rates ranging from 128 to 129 yen to the U.S. dollar. The Company purchases its shoes and leather goods, as well as various other raw materials, from companies located in Italy. The purchase of these items is completed in Euros. In order to reduce the effect of the fluctuation in the exchange rate between the Euro and the U.S. dollar, the Company may enter into foreign exchange contracts. At April 28, 2002, the Company had contracts maturing through May 31, 2002 to purchase 248,000 Euros at a rate of 0.85 U.S. dollars to the Euro. The outstanding forward contracts had a negative fair value of approximately $44,000 at April 28, 2002, which was recorded as a component of stockholders' equity. The Company is also exposed to market risks related to fluctuations in interest rates on its variable rate debt which consists of bank borrowings related to the mergers. The Company also holds fixed rate subordinated notes. The Company has entered into an interest rate collar agreement with a major financial institution to limit its exposure on $35 million of the variable rate debt. The agreement became effective on October 4, 1999 and will expire on July 7, 2002. The agreement sets a maximum rate for LIBOR contracts at 8.5%. The agreement also sets a minimum rate of 5.37%. During fiscal 2001, LIBOR decreased below the floor rate and the Company began making payments under the agreement. Since LIBOR rates are currently less than the floor rate, $35 million of the Company's variable rate debt has effectively been converted to fixed rate debt. The interest rate collar agreement had a negative fair value of approximately $303,000 at April 28, 2002, which is included in accrued liabilities. For fixed rate debt, changes in interest rates generally affect the fair market value, but not earnings or cash flows. Conversely, for variable rate debt, changes in interest rates generally do not influence fair market value, but do affect future earnings and cash flows. The Company has managed its exposure to changes in interest rates by issuing part of its debt with a fixed interest rate. Holding the variable rate debt balance constant, each one percentage point increase in interest rates occurring on the first day of the year would result in an increase in interest expense for the coming year of approximately $1.4 million. 27 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 On May 17, 2002 the holders of the Company's mandatorily redeemable preferred stock, pursuant to an action by written consent, unanimously approved the Certificate of Amendment of Certificate of Designations and the Modification Agreement amending the terms of such preferred stock. Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits required by Item 601 of Regulation S-K. 3.1 Certificate of Amendment of Certificate of Designations 4.1 Modification Agreement (b) Reports on Form 8-K. On May 23, 2002, the Company filed a Current Report on Form 8-K reporting under Item 4 a change in the Company's independent public accountants. 28 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 thereunto duly authorized. June 11, 2002 ST. JOHN KNITS INTERNATIONAL, INCORPORATED By: /s/Bob Gray ----------------------------------- Bob Gray Chairman of the Board By: /s/Roger G. Ruppert ----------------------------------- Roger G. Ruppert Senior Vice President - Finance, Chief Financial Officer (Principal Financial Officer) 29 EXHIBIT INDEX Exhibit Sequentially Number Numbered Page Description of Exhibit 3.1 Certificate of Amendment of Certificate of Designations 4.1 Modification Agreement 30

ST JOHN KNITS INTERNATIONAL INC 10-Q