10-Q 1 e300747_10q-donnken.txt FORM 10-Q 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 September 30, 2003 ------------------ 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 0-21940 ------- Donnkenny, Inc. --------------- (Exact name of registrant as specified in its charter) Delaware 51-0228891 -------- ---------- (State or jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1411 Broadway, New York, NY 10018 --------------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (212) 790-3900 -------------- NOT APPLICABLE -------------- (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), Yes |X| No |_| and (2) has been the subject to such filing requirements for the past 90 days. Yes |X| No |_|. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes |_| No |X|. Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the latest practicable date. Common Stock $0.01 par value 4,367,417 ---------------------------- ---------------------------------- (Class) (Outstanding at November 11, 2003) DONNKENNY, INC AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS (FORM 10-Q) PART I - FINANCIAL INFORMATION Page ---- Item 1. Consolidated financial statements: Balance sheets as of September 30, 2003 (unaudited) and December 31, 2002..............................................1 Statements of operations for the three and nine months ended September 30, 2003 and 2002 (unaudited)......................2 Statements of cash flows for the nine months ended September 30, 2003 and 2002 (unaudited)............................3 Notes to Consolidated Financial Statements (unaudited)..........4-11 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.........................................12-17 Item 3. Quantitative and Qualitative Disclosures about Market Risk...........18 Item 4. Controls and Procedures..............................................18 PART II - OTHER INFORMATION Item 1. Legal Proceedings....................................................19 Item 6 Exhibits and Reports on Form 8-K..................................19-20 Signatures........................................................21 Certifications.................................................22-25 DONNKENNY, INC. AND SUBSIDIARIES Consolidated Balance Sheets (in thousands, except per share data)

See accompanying notes to consolidated financial statements. 1 DONNKENNY, INC. AND SUBSIDIARIES Consolidated Statements of Operations (in thousands, except share and per share data) (unaudited)

See accompanying notes to consolidated financial statements. 2 DONNKENNY, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (unaudited)

See accompanying notes to consolidated financial statements. 3 DONNKENNY, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared by the Company pursuant to the Rules of the Securities and Exchange Commission ("SEC") and, in the opinion of management, include all adjustments (consisting of normal recurring accruals) necessary for the fair presentation of financial position, results of operations and cash flows. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such SEC rules. The Company believes the disclosures made are adequate to make such financial statements not misleading. The results for the interim periods presented are not necessarily indicative of the results to be expected for the full year. These financial statements should be read in conjunction with the Company's Report on Form 10-K for the year ended December 31, 2002. Balance sheet data as of December 31, 2002 have been derived from audited financial statements of the Company. Certain reclassifications have been made to the 2002 financial statements to conform to the 2003 presentation. NOTE 2 - STOCK BASED COMPENSATION The Company accounts for its stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the Common Stock on the dates of grant. The following table details the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Statement ("SFAS") No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, to stock-based employee compensation.

4 The following weighted-average assumptions were used in the Black-Scholes option-pricing model for grants in 2003: dividend yield of 0%, volatility of 251%; risk-free interest rate of 3.96%; and an expected life of 8 years. Information regarding the Company's stock option plan is summarized below:

The options outstanding at September 30, 2003 range in exercise price as follows:

NOTE 3 - EARNINGS PER SHARE Basic net income (loss) per share is computed by dividing net income (loss) loss attributable to common stockholders by the weighted number of common shares outstanding during the period. Diluted net loss per share is computed by dividing the net loss attributable to common stockholders by the weighted average number of common and common equivalent shares outstanding during the period. The effect of outstanding stock option awards is antidilutive and, accordingly, 11,065 and 26,208 stock options which are common stock equivalents have been excluded from the calculation of diluted loss per share for the three and nine months periods ended September 30, 2003, respectively. 5 NOTE 4 - INVENTORIES Inventories consist of the following: Sept 30, December 31, 2003 2002 -------- ------------ (In thousands) Raw materials ...................... $ 2,507 $ 701 Work-in-process .................... 1,401 143 Finished goods ..................... 14,284 16,411 Reserves ........................... (470) (1,306) -------- -------- $ 17,722 $ 15,949 ======== ======== Inventories at September 30, 2002 were $21.0 million consisting primarily of finished goods. NOTE 5 - DEBT On June 29, 1999, the Company and its operating subsidiaries signed a three-year credit agreement (the "Credit Agreement") with CIT Group/Commercial Services. The Credit Agreement provided the Company with a $75 million facility comprised of a $72 million revolver with sub-limits up to $52 million for direct borrowings, $35 million for letters of credit, certain overadvances and a $3 million term loan which was paid in full as of June 30, 2002. The Credit Agreement provides for advances of (i) up to 90% of eligible accounts receivable plus (ii) up to 60% of eligible inventory plus (iii) up to 60% of the undrawn amount of all outstanding letters of credit plus (iv) allowable overadvances. Collateral for the Credit Agreement includes a first priority lien on all assets of the Company including accounts receivable, machinery, equipment, trademarks, intangibles and inventory, a first mortgage on all real property and a pledge of the Company's stock interest in the Company's operating subsidiaries, Donnkenny Apparel, Inc. and Beldoch Industries Corporation. The Credit Agreement contains numerous financial and operational covenants, including limitations on additional indebtedness, liens, dividends, stock repurchases and capital expenditures. In addition, the Company is required to maintain specified levels of tangible net worth and comply with a requirement for minimum earnings before depreciation, amortization, interest and taxes (EBITDA) and a minimum interest coverage ratio, all based upon the Company's annual business plan approved by the lender. Effective January 1, 2003, the Company established covenants and the level of allowable overadvances with the lender, through an Amendment to the Credit Agreement dated March 27, 2003, to support its 2003 business plan. The Amendment also amended the interest rate on the revolving credit borrowings to the prime rate plus one and one-quarter percent (5.25% at September 30, 2003). No fee was paid in connection with this Amendment The Company also has a factoring agreement with CIT Group/Commercial Services. The factoring agreement provides for a factoring commission equal to .35% of gross sales, plus certain customary charges. The factoring agreement provides for annual renewals on the anniversary date unless either party terminates the Agreement in accordance with its terms. 6 Effective June 30, 2003, the Company through an Amendment and Waiver Agreement dated August 11, 2003, extended the Final Maturity Date of the Credit Agreement to June 30, 2007. This Amendment provides the Company with a $65 million facility, and amends the anniversary date of the factoring agreement from December 2003 to June 30, 2004 with annual renewals thereafter. Fees paid in connection with this Amendment were $243,750. All other terms and conditions of the Revolving Credit Agreement remain unchanged. As of September 30, 2003, the Company was not in compliance with the quarterly financial covenants. The Lender has waived this non-compliance. No fee was paid in connection with the Waiver. At September 30, 2003 and 2002, direct borrowings under the revolving credit facility were $28.8 million and $30.0 million, respectively. Additionally, the Company had letters of credit outstanding of $6.9 million and $10.1 million, respectively. NOTE 6 - GOODWILL AND INTANGIBLE ASSETS Intangible assets consisted of licenses of $0.8 million with indefinite lives and $0.5 million with definite lives at September 30, 2003. At December 31, 2002 intangible assets consisted of $0.8 million of licenses with indefinite lives. The $0.8 million of intangible assets related to the Pierre Cardin license acquired from Beldoch Industries Corporation ("Beldoch") in 1995, from the Beldoch acquisition, and is classified as an intangible asset with an indefinite life in the Company's September 30, 2003 and December 31, 2002 Consolidated Balance Sheets. Prior to January 1, 2002, the Company had net intangible assets of $29.6 million on its Consolidated Balance Sheet. The intangible assets included goodwill of $25.4 million, which represented the excess purchase price over fair value of net assets acquired. The assets acquired related to the acquisitions of the Company in 1989 following a change in control, the sportswear division of Oak Hill Sportswear Corporation ("Oak Hill"), Beldoch in 1995, and Ann Travis in 2000. Goodwill was amortized on a straight-line basis over expected periods to be benefited, ranging from 10 to 40 years. Also included in the intangible assets were $4.2 million of costs related to the Pierre Cardin license acquired by the Company in connection with the Beldoch acquisition, which were amortized on a straight-line basis over 20 years. As a result of adopting SFAS No. 142, "Goodwill and Other Intangible Assets," on January 1, 2002, the Company ceased the amortization of goodwill and other intangible assets with indefinite lives and determined that the value of its intangible assets had been impaired. An impairment charge of $28.7 million, recorded as a change in accounting principle, was calculated based upon a valuation of the Company's market capitalization on January 1, 2002, adjusted for an estimated premium that a willing buyer would assign to the market capitalization in the event of a sale of the Company. The premium was based on an average of such premiums paid in similar transactions in the industry. The impairment charge consisted of $25.4 million related to goodwill and $3.3 million related to the license. The Company did not record an income tax benefit related to this charge. On May 1, 2003, the Company entered into a licensing arrangement to manufacture and sell coats under the Bill Blass(R), Bill Blass Signature(R) and Blassport(R) labels. The Company recorded an intangible asset of approximately $0.5 million for the costs incurred in connection with the acquisition of the licenses. The intangible asset is being amortized over the expected life of the licenses until December 31, 2009. 7 The minimum licensing commitments under the Company's licensing arrangements are disclosed in Note 8. NOTE 7 - RECENT ACCOUNTING PRONOUNCEMENTS In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation--Transition and Disclosure--an amendment of FASB Statement No. 123". SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation", to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The disclosure amendments to Statement 123 contained in SFAS No. 148 are effective for financial statements for fiscal years ending after December 15, 2002. The Company has adopted the disclosure provisions of SFAS No. 148. In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. The Company does not expect adoption of SFAS No. 149 to have an impact on the consolidated financial statements as the Company does not engage in derivative or hedging activity. In May 2003, the FASB issued SFAS 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity," effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a freestanding financial instrument that is within its scope as a liability (or an asset in some circumstances). The adoption of SFAS 150 will not have an impact on the Company's reported consolidated financial position, results of operations or cash flows. NOTE 8 - COMMITMENTS AND CONTINGENCIES a. On April 27, 1998, Wanda King, a former employee of the Company, commenced an action against the Company in the United States District Court for the Western District of Virginia. In her complaint, the Plaintiff sought damages in excess of $8.0 million claiming that she was constructively discharged by the Company. The Company interposed an Answer to the amended Complaint denying the material allegations asserted in the Complaint and brought a motion for summary judgment to dismiss the case. On October 22, 2001, the Magistrate Judge, after considering the Motion for Summary Judgment, recommended to the United States District Court that the case against the Company be dismissed in its entirety. The Plaintiff objected to the recommendation of the Magistrate Judge. By Order dated February 25, 2002, the United States District Judge granted the Company's motion for summary judgment. The Plaintiff appealed this determination to the United States Court of Appeals for the Fourth Circuit. On appeal, the United States Court of Appeals for the Fourth Circuit reversed the United States District Court's decision and remanded the case back to the District Court for further consideration. The Company renewed its motion for summary judgment and the District Court, by decision dated November 6, 2003, 8 granted the motion in part and dismissed the claims of the Plaintiff for infliction of emotional distress and let stand Plaintiff's claim for wrongful discharge. Further discovery will be conducted regarding the Plaintiff's claim prior to trial. b. The Company is also a party to legal proceedings arising in the ordinary course of its business. Management believes that the ultimate resolution of these proceedings will not, in the aggregate, have a material adverse effect on the financial condition, results of operations, liquidity or business of the Company. c. The Company's License Agreements for the manufacture of garments under licensed trademarks provide for payments of annual minimum royalty amounts. The Company estimates that the minimum guaranteed royalties for these Licenses are approximately $8.8 million as of September 30, 2003. These minimum payments are payable over the terms of the Agreements, including renewal periods, through 2009. There are no maximums to the royalty amounts. d. On June 16, 2003, the Company entered into a licensing arrangement to manufacture knits, sweaters, and woven tops under the Z. Cavaricci label. The Company intends to begin shipments with the Spring 2004 season. The guaranteed minimum royalties for this license are reflected in the amount disclosed in Note 8c. e. On September 10, 2003, the Company entered into a licensing arrangement to manufacture women's overcoats under the Nicole Miller label. The Company intends to begin shipments with the Fall 2004 season. The guaranteed minimum royalties for this license are reflected in the amount disclosed in Note 8c. f. The Company has agreed to purchase $2.7 million of raw materials in connection with the manufacturing of coats. It is estimated that 60% of this amount will be purchased in 2003 and the balance in 2004. To date, approximately $1.0 million has been purchased against this commitment. NOTE 9 - SUBSEQUENT EVENTS a. On October 1, 2003, the Company acquired certain assets of Robyn Meredith Inc.("RMI"). The assets that were acquired were the assets of RMI devoted to its women's sportswear business and consisted of inventory of finished goods, raw materials and trim, certain tradenames including the name "Robyn Meredith", open purchase orders and certain equipment that was subject to equipment lease agreements. The Company intends to continue to use these assets for the manufacture and distribution of women's sportswear. The acquisition is a component in the Company's long-term strategy to be a private label and branded business and will enable the Company to expand its avenues of distribution. 9 The purchase price paid to RMI by the Company was $4.6 million, of which $3.4 million was delivered at the closing of the transaction and $1.2 million was represented by the delivery of a Promissory Note providing for equal monthly payments over three years without interest discounted to $1.1 million. The total purchase price including professional fees was $4.8 million. The Company also took over a lease obligation for facilities in Burlington New Jersey to be used primarily for office space and for some finishing and shipping functions. The lease for the premises provides for a three year term plus payment of a pro-rata portion of common expenses for the building. The Company also entered into a month to month agreement for temporary space in the Burlington New Jersey building. 10 The following table summarizes the estimated fair values of the assets acquired. ($000s) Inventory $3,104 Intangibles 50 Goodwill 1,633 ------ Total assets acquired $4,787 ====== Pro Forma Financial Information: The pro forma financial information presented below gives effect to the Robyn Meredith acquisition as if it had occurred as of the beginning of the Company's fiscal year 2002. The information presented below is for illustrative purposes only and is not indicative of results that would have been achieved or results which may be achieved in the future.

b. Effective October 1, 2003, Harry A. Katz resigned as a member of the Company's Board of Directors. 11 DONNKENNY, INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Comparison of Nine Months Ended September 30, 2003 and 2002 Net sales decreased by $17.3 million, or 22.3% from $77.5 million in the first nine months of 2002 to $60.2 million in the first nine months of 2003. The decline was primarily due to the continuing slow retail environment, uncertainty about the war with Iraq and low consumer confidence. The Company is also experiencing increased competition from both retailers private label brands as well as recognizable brands, which caused a drop in the Company's core business. Gross profit for the first nine months of 2003 was $14.8 million, or 24.5% of net sales, compared to $19.5 million, or 25.2% of net sales, during the first nine months of 2002. The decrease in gross profit was due to the drop in sales and the sell off of slow moving inventory. Selling, general and administrative expenses for the first nine months of 2003 were $15.5 million compared to $16.2 million in the first nine months of 2002. The decrease in selling, general and administrative expenses was primarily due to reductions in headcount and reductions in distribution, administration and product-related expenses. Net interest expense decreased from $1.6 million during the first nine months of 2002 to $1.0 million during the first nine months of 2003. The decrease was attributable to lower revolving credit borrowings under the credit agreement, a lower interest rate and interest received from an income tax refund. The Company recorded a provision for state and local income taxes of $0.135 million in the first nine months of 2002 compared to $0.058 million in 2003. In the first nine months of 2003, an audit of prior years State income tax returns was completed. As a result, the Company received additional refunds of $0.06 million. In the first nine months of 2002, the Company recorded an impairment charge related to goodwill and intangible assets of $28.7 million as a change in accounting principle upon the adoption of SFAS No. 142. Comparison of Quarters Ended September 30, 2003 and 2002 Net sales decreased by $7.3 million, or 23.7% from $30.7 million in the third quarter of 2002 to $23.4 million in the third quarter 2003. The decline was primarily due to the slow retail environment, competitive price reductions, and low consumer confidence which caused a drop in the Company's core businesses. The Company is also experiencing increased competition from both retailers private label brands as well as recognizable brands, which caused a drop in the Company's core business. Gross profit for the third quarter of 2003 was $5.2 million, or 22.0% of net sales, compared to $7.9 million, or 25.9% of net sales, during the third quarter of 2002. The decrease in gross profit in dollars was due to the drop in sales as a result of the slow retail environment. Selling, general and administrative expenses for the third quarter 2003 was $5.1 million compared to $5.8 million in the third quarter of 2002. The decrease in selling, general and administrative expenses was primarily due to reductions in headcount and reductions in distribution, sales, administrative and product-related expenses. 12 Net interest expense decreased from $0.5 million during the third quarter of 2002 to $0.4 million during the third quarter of 2003. The decrease was attributable to lower revolving credit borrowings under the credit agreement and a lower interest rate. The Company recorded a provision for state and local income taxes of $0.03 million in third quarter 2003 and $0.05 million in 2002. New Licensing Agreements On May 1, 2003, the Company entered into a licensing arrangement to manufacture and sell coats under the Bill Blass(R), Bill Blass Signature(R) and Blassport(R) labels. The Company began shipments with the Fall 2003 season. On June 16, 2003, the Company entered into a licensing arrangement to manufacture knits, sweaters, and woven tops under the Z. Cavaricci label. The Company intends to begin shipments with the Spring 2004 season. On September 10, 2003, the Company entered into a licensing arrangement to manufacture women's overcoats under the Nicole Miller label. The Company intends to begin shipments with the Fall 2004 season. Liquidity and Capital Resources The Company's liquidity requirements arise from the funding of working capital needs, primarily inventory and accounts receivable, and interest and principal payments related to certain indebtedness and capital expenditures. The Company's borrowing requirements for working capital fluctuate throughout the year. On June 29, 1999, the Company and its operating subsidiaries signed a three-year credit agreement (the "Credit Agreement") with CIT Group/Commercial Services. The Credit Agreement provided the Company with a $75 million facility comprised of a $72 million revolver with sub limits up to $52 million for direct borrowings, $35 million for letters of credit, certain overadvances and a $3 million term loan which was paid in full as of June 30, 2002. The Credit Agreement provides for advances of (i) up to 90% of eligible accounts receivable plus (ii) up to 60% of eligible inventory plus (iii) up to 60% of the undrawn amount of all outstanding letters of credit plus (iv) allowable overadvances. Collateral for the Credit Agreement includes a first priority lien on all assets of the Company including, accounts receivable, machinery, equipment, trademarks, intangibles and inventory, a first mortgage on all real property and a pledge of the Company's stock interest in the Company's operating subsidiaries, Donnkenny Apparel, Inc. and Beldoch Industries Corporation. The Credit Agreement contains numerous financial and operational covenants, including limitations on additional indebtedness, liens, dividends, stock repurchases and capital expenditures. In addition, the Company is required to maintain specified levels of tangible net worth and comply with a requirement for minimum earnings before depreciation, amortization, interest and taxes (EBITDA) and a minimum interest coverage ratio, all based upon the Company's annual business plan approved by the lender. 13 Effective January 1, 2003, the Company established covenants and the level of allowable overadvances with the lender, through an Amendment to the Credit Agreement dated March 27, 2003, to support its 2003 business plan. The Amendment also amended the interest rate on the revolving credit borrowings to the prime rate plus one and one-quarter percent (5.25% at September 30, 2003). No fee was paid in connection with this Amendment. The Company also has a factoring agreement with CIT Group/Commercial Services. The factoring agreement provides for a factoring commission equal to .35% of gross sales, plus certain customary charges. The factoring agreement provides for annual renewals on the anniversary date unless either party terminates the Agreement in accordance with its terms. Effective June 30, 2003, the Company through an Amendment and Waiver Agreement dated August 11, 2003, extended the Final Maturity Date of the Credit Agreement to June 30, 2007. This Amendment provides the Company with a $65 million facility, and amends the anniversary date of the factoring agreement from December 2003 to June 30, 2004 with annual renewals thereafter. Fees paid in connection with this Amendment were $243,750. All other terms and conditions of the Revolving credit Agreement remain unchanged. As of September 30, 2003, the Company was not in compliance with the quarterly financial covenants. The Lender has waived this non-compliance. No fee was paid in connection with the Waiver. During the first nine months of 2003, cash used in operating activities was $4.2 million, principally as the result of decreases in accounts payable and increases in inventory and prepaid expenses and other current assets partially offset by decreases in due from factor. On a comparable basis, net inventories at September 30, 2003 were $3.3 million less than September 30, 2002. During the first nine months of 2002, cash provided by operating activities was $5.6 million, principally as the result of decreases in accounts receivable and due from factor and prepaid expenses and increases in accounts payable partially offset by increases in inventories and decreases in accrued expenses and other current liabilities. Cash used in investing activities during the first nine months of 2003 was $0.6 million, mainly for the purchase of fixed assets, principally computer equipment and related software and costs associated with the acquisition of a license. Cash used in investing activities during the first nine months of 2002 included $0.5 million for the purchase of fixed assets, principally computer equipment and related software, partially offset by $0.1 million from the sale of fixed assets. Cash provided by financing activities during the first nine months of 2003 was $4.8 million, which represents net borrowings under the revolver of $5.1 million and repayments of $0.3 million on the term loan. Cash used in financing activities during the first nine months of 2002 was $5.3 million, which represents net repayments under the revolver of $4.5 million and repayments of $0.8 million on the term loan. The Company believes that cash flows from operations and amounts available under the Credit Agreement, as amended, will be sufficient for its needs for the foreseeable future. 14 Contractual Commitments and Contingent Liabilities The following table summarizes the Company's contractual commitments at September 30, 2003:

The Company has not provided any financial guarantees as of September 30, 2003. Seasonality of Business and Fashion Risk The Company's principal products are organized into seasonal lines for resale at the retail level during the Spring, Summer, Transition, Fall and Holiday seasons. Typically, the Company's products are designed as much as one year in advance and manufactured approximately one season in advance of the related retail selling season. Accordingly, the success of the Company's products is often dependent on the ability to successfully anticipate the needs of retail customers and the tastes of the ultimate consumer up to a year prior to the relevant selling season. 15 Critical Accounting Policies and Estimates The Company's significant accounting policies are more fully described in Note 1 to the Annual Consolidated Financial Statements filed on Form 10-K (not presented herein). Certain of the Company's accounting policies require the application of significant judgment by management in selecting the appropriate assumptions for calculating financial estimates. By their nature, these judgments are subject to an inherent degree of uncertainty. These judgments are based on historical experience, observation of trends in the industry, information provided by customers and information available from other outside sources, as appropriate. Critical accounting policies include: Revenue Recognition - The Company recognizes sales upon shipment of products to customers as title and risk of loss pass upon shipment. Provisions for estimated uncollectible accounts, discounts and returns and allowances are provided when sales are recorded based upon historical experience and current trends. While such amounts have been within expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same rates as in the past. Accounts Receivable and Due from Factor - Accounts Receivable and due from factor as shown on the Consolidated Balance Sheets, are net of allowances and anticipated discounts. An allowance for doubtful accounts is determined through analysis of the aging of accounts receivable at the date of the financial statements, assessments of collectibility based on historic trends and an evaluation of the impact of economic conditions. The allowance for doubtful accounts is not significant since the Company sells a substantial portion of its trade receivables to a commercial factor, without recourse, up to maximum credit limits established by the factor for each individual account. Receivables sold in excess of these limitations are subject to recourse in the event of non-payment by the customer. An allowance for discounts is based on those discounts relating to open invoices where trade discounts have been extended to customers. Costs associated with potential returns of products as well as allowable customer markdowns and operational charge backs, net of expected recoveries, are included as a reduction to net sales and are part of the provision for allowances. These provisions result from seasonal negotiations as well as historic deduction trends, net expected recoveries and the evaluation of current market conditions. The Company's historical estimates of these costs have not differed materially from actual results. Inventories - Inventory is stated at the lower of cost or market, cost being determined on the first-in, first-out method. Reserves for slow moving and aged merchandise are provided based on historical experience and current product demand. Inventory reserves for slow moving and aged merchandise were $0.5 million and $1.3 million at September 30, 2003 and December 31, 2002, respectively. Inventory reserves decreased due to the levels and composition of inventory on hand at September 30, 2003. Additionally, during the first nine months of 2003, the Company directly wrote down the value of certain merchandise, which reduced the cost of finished goods and reduced corresponding inventory reserves. The Company evaluates the adequacy of the reserves quarterly. While markdowns have been within expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same level of markdowns as in the past. 16 Valuation of Long-Lived Assets - The Company periodically reviews the carrying value of its long-lived assets for continued appropriateness. This review is based upon projections of anticipated future undiscounted cash flows. While the Company believes that its estimates of future cash flows are reasonable, different assumptions regarding such cash flows could materially affect evaluations. Income Taxes - The Company provides for income taxes only to the extent that it expects to pay taxes (primarily state franchise and local taxes). As of December 31, 2002, the Company's cumulative net operating loss (NOL) carryforward of $18.3 million for federal income taxes and $29.4 million for state income taxes, resulted in estimated tax benefits of $7.6 million. However, the Company has recorded a valuation allowance against these deferred tax assets due to the size of the NOL carryforward and the Company's history of unprofitable operations. However, should the Company conclude that future profitability is reasonably assured, the value of the deferred tax asset would be increased by eliminating some or all of the valuation allowance. Subsequent revisions to the estimated value of the deferred tax asset could cause the Company's provision for income taxes to vary from period to period; payments would remain unaffected until the benefit of the NOL is utilized. Forward Looking Statements - This Form 10-Q (including but not limited to the sections hereof entitled "Business" and "Management's Discussion and Analysis") contains or incorporates by reference forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Where any such forward-looking statement includes a statement of the assumptions or bases underlying such forward-looking statement, the Company cautions that assumed facts or bases almost always vary from the actual results, and the differences between assumed facts or bases and actual results can be material, depending on the circumstances. Where, in any forward-looking statement, the Company or its management expresses an expectation or belief as to future results, there can be no assurance that the statement of the expectation or belief will result, or be achieved or accomplished. The words "believe", "expect", "estimate", "project", "seek", "anticipate" and similar expressions may identify forward-looking statements. 17 Item 3. Quantitative and Qualitative Disclosures about Market Risk Interest Rate Risk - The Company is subject to market risk from exposure to changes in interest rates based primarily on its financing activities. The market risk inherent in the financial instruments represents the potential loss in earnings or cash flows arising from adverse changes in interest rates. These debt obligations with interest rates tied to the prime rate are described in "Liquidity and Capital Resources", as well as Note 4 of the Notes to the Consolidated Financial Statements. The Company manages these exposures through regular operating and financing activities. The Company has not entered into any derivative financial instruments for hedging or other purposes. The following quantitative disclosures are based on the prevailing prime rate. These quantitative disclosures do not represent the maximum possible loss or any expected loss that may occur, since actual results may differ from these estimates. At September 30, 2003 and 2002, the carrying amounts of the Company's revolving credit borrowings and term loans approximated fair value. Effective January 1, 2003, the Company's revolving credit borrowings under its Credit Agreement bear interest at the prime rate plus one and one-quarter percent (5.25% at September 30, 2003). As of September 30, 2003, a hypothetical immediate 10% adverse change in prime interest rates (from 4.0% to 4.4%) relating to the Company's revolving credit borrowings would have a $0.1 million unfavorable impact on the Company's earnings and cash flows over a one-year period. Item 4. Controls and Procedures The Company's management with the participation of Daniel H. Levy, the Chief Executive Officer and Maureen d Schimmenti, the Chief Financial Officer of the Company has evaluated the effectiveness of the Company's disclosure controls and procedures as of the end of the period covered by this report. Based on this evaluation the Company's Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures are effective in alerting them on a timely basis to material information required to be included in the reports that it files or submits under the Securities and Exchange Act of 1934, as amended. Such evaluation did not identify any change in the Company's internal control over financial reporting that occurred during the quarter ended September 30, 2003, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 18 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings On April 27, 1998, Wanda King, a former employee of the Company, commenced an action against the Company in the United States District Court for the Western District of Virginia. In her complaint, the Plaintiff sought damages in excess of $8.0 million claiming that she was constructively discharged by the Company. The Company interposed an Answer to the amended Complaint denying the material allegations asserted in the Complaint and brought a motion for summary judgment to dismiss the case. On October 22, 2001, the Magistrate Judge, after considering the Motion for Summary Judgment, recommended to the United States District Court that the case against the Company be dismissed in its entirety. The Plaintiff objected to the recommendation of the Magistrate Judge. By Order dated February 25, 2002, the United States District Judge granted the Company's motion for summary judgment. The Plaintiff appealed this determination to the United States Court of Appeals for the Fourth Circuit. On appeal, the Fourth Circuit reversed the District Court's decision and remanded the case back to the District Court for further consideration. The Company renewed its motion for summary judgment and the District Court, by decision dated November 6, 2003, granted the motion in part and dismissed the claims of the Plaintiff for infliction of emotional distress and let stand Plaintiff's claim for wrongful discharge. Further discovery will be conducted regarding the Plaintiff's claim prior to trail. The Company is also a party to legal proceedings arising in the ordinary course of its business. Management believes that the ultimate resolution of these proceedings will not, in the aggregate, have a material adverse effect on financial condition, results of operations, liquidity or business of the Company. ITEM 2. Not Applicable ITEM 3. Not Applicable ITEM 4. Not Applicable ITEM 5. Not Applicable ITEM 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description of Exhibit ----------- ---------------------- 31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 19 (b) Reports on Form 8-K On September 2, 2003, the Company filed a Current Report on Form 8-K reporting the designation of Mahoney Cohen & Company, CPA, P.C. as the Company's new independent auditors. On September 3, 2003, the Company filed a Current Report on Form 8-KA regarding the designation of Mahoney Cohen & Company, CPA, P.C. as new independent auditors. On September 19, 2003, the Company filed a Current Report on Form 8-K announcing plans to acquire the Robyn Meredith Sportswear business. On October 7, 2003, the Company filed a Current Report on Form 8-K reporting the acquisition of the assets of the Robyn Meredith Sportswear business. 20 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. Donnkenny, Inc. Registrant Date: November 13, 2003 /s/ Daniel H. Levy ------------------------------------ Daniel H. Levy Chairman of the Board, Chief Executive Officer Date: November 13, 2003 /s/ Maureen d. Schimmenti ------------------------------------ Maureen d. Schimmenti Vice President and Chief Financial Officer, (Principal Financial Officer) 21

DONNKENNY INC 10-Q