10-Q 1 e400674_10q-donnkenny.txt QUARTERLY REPORT 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 June 30, 2004 ------------- 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 August 9, 2004) DONNKENNY, INC AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS (FORM 10-Q)

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, 2003. Balance sheet data as of December 31, 2003 have been derived from audited financial statements of the Company. 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 exercise prices 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 2004: dividend yield of 0%, volatility of 222%; risk-free interest rate of 4.54%; and an expected life of 8 years. Information regarding the Company's stock option plan is summarized below:

The options outstanding at June 30, 2004 range in exercise price as follows:

NOTE 3 - EARNINGS PER SHARE Basic net loss per share is computed by dividing net loss attributable to common stockholders by the weighted number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income attributable to common stockholders by the weighted average number of common and common equivalent shares outstanding during the period. For both the three and six months ended June 30, 2004, the effect of options to purchase 323,412 shares of the Company's common stock at less than market value was not considered for the diluted earnings per share calculation as their effect would be antidilutive. For the three and six months ended June 30, 2003, the effect of the options to purchase 22,942 and 39,274 shares, respectively, of the Company's common stock at less than market value was not considered for the diluted earnings per share calculation as their effect would be antidilutive. -5- NOTE 4 - INVENTORIES Inventories consist of the following: June 30, December 31, 2004 2003 ---- ---- (In thousands) Raw materials ........................ $ 4,180 $ 3,317 Work-in-process ...................... 1,220 2,189 Finished goods ....................... 15,322 15,873 Reserves ............................. (387) (1,251) -------- -------- $ 20,335 $ 20,128 ======== ======== Inventories at June 30, 2003 were $16.7 million consisting primarily of finished goods. NOTE 5 - DEBT On June 29, 1999, the Company and its operating subsidiaries signed a Credit Agreement (the "Credit Agreement") with CIT Group/Commercial Services (the "Lender"). The Credit Agreement initially 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 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 its 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 plans approved by the Lender. In July 2000, the Credit Agreement was amended to provide for an additional $1.3 million term loan to finance an acquisition. This term loan bore interest at the prime rate plus 2% through March 2003, at which time this term loan was paid. On March 28, 2001, the Company entered into an Amendment and Waiver Agreement to extend the Final Maturity Date of the original agreement to June 30, 2004, to waive existing events of default under the Credit Agreement as of December 31, 2000 with respect to the Company's non-compliance with covenants related to minimum interest coverage, EBITDA and Tangible Net Worth, and to amend certain other provisions of the Credit Agreement including covenants and the level of allowable overadvances to support the Company's 2001 business plan. Pursuant to this amendment, the interest rate on borrowings was increased to 2.0% above the prime rate effective January 1, 2001. A fee of $200,000 was paid in connection with the Amendment and Waiver. -6- Effective January 1, 2002, the Company established covenants and the level of allowable overadvances with the Lender to support its 2002 business plan. This Amendment and Waiver Agreement also amended the interest rate on the revolving credit borrowings to the prime rate plus one and three quarters percent and provide for an additional interest rate reduction effective July 1, 2002 if certain objectives were achieved. No fee was paid in connection with the Amendment and Waiver. The Company achieved the objectives and received an additional rate reduction effective July 1, 2002. The interest rate on the revolving credit borrowings was prime plus one and one-half percent. 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. No fee was paid in connection with the Amendment. Effective June 30, 2003, the Company through an Amendment and Waiver Agreement dated August 11, 2003, extended the Credit Agreement to June 30, 2007. This Amendment provides the Company with a $65 million facility; the sublimits have remained the same. The interest rate on the revolving credit borrowings is the current prime rate plus one and one-quarter percent (5.50% at June 30, 2004). Fees paid in connection with this Amendment were $243,750. All other terms and conditions of the Revolving Credit Agreement remained unchanged. As of December 31, 2003, the Company was not in compliance with the quarterly financial covenants of the Agreement. The Lender waived this non-compliance. The Company paid a fee of $100,000 in connection with this waiver. Effective January 1, 2004, the Company established covenants and the level of allowable overadvances with the Lender, through an Amendment to the Credit Agreement dated March 26, 2004, to support its 2004 business plan. No fee was paid in connection with this Amendment. As of June 30, 2004, the Company was not in compliance with the quarterly financial covenants. The Lender has waived this non-compliance. The Company paid a fee of $25,000 in connection with this waiver. The Company has recorded its obligation to the Lender as a current liability at June 30, 2004 since the Company projects that it will not be in compliance with its quarterly financial covenants over the next six months. The Company is dependant upon the continued support of its Lender to fund its operations for the balance of the year and the future. Any change in the Lender's support could have an adverse effect on the Company's business and would cause the Company to seek alternative financing arrangements. The Company believes that with the support of its Lender and with cash flows from operations, the cash flow needs of the Company will be sufficient for the foreseeable future. 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 renews annually in June each year unless either party to the agreement gives appropriate notice of non-renewal. In connection with the acquisition of Robyn Meredith (see Note 9 to the Consolidated Financial Statements), a note payable of $1.1 million was issued. This note is payable in monthly installments of $33,333 including imputed interest at an interest rate of 5.25%. The final payment will be due October 2006. -7- At June 30, 2004 and December 31, 2003, the Company was contingently liable for outstanding letters of credit issued amounting to $5.3 million and $6.6 million, respectively. NOTE 6 - GOODWILL AND INTANGIBLE ASSETS Goodwill and Other Intangible Assets consisted of the following at June 30, 2004 and December 31, 2003: (In Thousands) June 30, Dec. 31, 2004 2003 ---- ---- Goodwill $ 1,641 $ 1,641 Covenant not to Compete 50 50 License agreements 1,333 1,333 Accumulated amortization (235) (51) ------- ------- $ 2,789 $ 2,973 ======= ======= The goodwill which represented the excess purchase price over the fair value of the net assets acquired and the covenant not to compete are attributable to the acquisition of Robyn Meredith (see Note 9 to the Consolidated Financial Statements). The covenant not to compete is being amortized over the contract life of four years. License Agreements of $0.8 million are attributable to the Pierre Cardin license acquired which was classified as an intangible asset with an indefinite life on the Company's December 31, 2003 Consolidated Balance Sheet because the Company held the license in perpetuity. On February 12, 2004, the Company signed a new Pierre Cardin license to provide for a term of three years in exchange for reduced future minimum payments. Beginning in 2004, this license is being amortized over three years. License Agreements of $0.5 million are attributable to costs in connection with the acquisition of the Company's licensing agreement to manufacture and sell coats under the Bill Blass(R), Bill Blass Signature(R), and Blassport(R) Labels. This license is being amortized over the expected lives of the licenses through 2009. -8- NOTE 7 - RECENT ACCOUNTING PRONOUNCEMENTS In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). FIN 46 requires that a variable interest entity be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation requirements apply to the first fiscal year or interim period ending after March 31, 2004. The adoption of FIN 46 did not have an impact on the Company's consolidated financial position or results of operations. 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 adoption of SFAS No. 149 did not 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 did not have an impact on the Company's reported consolidated financial position, results of operations or cash flows. NOTE 8 - 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. By Order dated May 4, 2004, based upon the case being settled, the action was dismissed. b. The Company is 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. -9- NOTE 9 - ROBYN MEREDITH ACQUISITION 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 principally of inventory of finished goods, raw materials and trim and certain tradenames including the name "Robyn Meredith". The Company intends to continue to use these assets for the manufacture and distribution of women's sportswear. The purchase price paid to RMI by the Company was $4.6 million (excluding any future purchase price adjustments based on subsequent performance thresholds) which was determined by valuing the inventory and through negotiations between the parties as to the balance of the purchase price. 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 2003. Actual results for 2004 have been included for comparative purposes. 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.

-10- DONNKENNY, INC. AND SUBSIDIARIES ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introductory Overview The Company is engaged in the women's apparel business. The Company's business consists of importing and marketing women's apparel, consisting primarily of women's sportswear and coats, to its customers who in turn sell the Company's products to the ultimate retail consumers. The business of the Company is highly competitive. The Company's products consist of its in-house brand names ("In-House Branded Products") as well as those produced under a licensing arrangement for the use of Pierre Cardin(R), Harve Benard(R), Bill Blass(R), Z. Cavaricci(R) and Nicole Miller(R) trademarks ("Licensed Products"). In addition to selling its In-House Branded and Licensed Products to its customers, the Company develops specific product ("Private Label Products") for some of its larger accounts, such as mass merchandisers and national chains. The women's apparel business is characterized by a large number of small companies selling branded and unbranded merchandise, and by several large companies that have developed widespread consumer recognition of the trademarks and brand names associated with merchandise sold by these companies. In addition, retailers to whom the Company sells its products have sought to expand the development and marketing of their own brands and to obtain women's apparel products directly from the same sources from which the Company obtains its products. The Company's women's apparel business provides product for department stores, specialty stores, regional chains, discounters and warehouse clubs. Sportswear is marketed for four selling seasons a year. The Company's women's coat products, consisting of outerwear and rainwear, are marketed for two specific selling seasons. To be competitive, the Company is required to create a substantially new line of products for each selling season. In this competitive environment, the Company's In-House Branded Products, which do not have widespread consumer recognition, although they are well known by the Company's retail customers, must compete with widely recognized brand names of product produced by the Company's competitors. The Company's Licensed Products have widespread brand recognition but they must compete against other widely known In-House and National brands. In addition, the Company makes presentations throughout the year to Private Label accounts. The Company does not have long-term contracts with any of its customers and, therefore, its business is subject to unpredictable increases and decreases in sales depending upon the size and number of orders that the Company receives each time it presents its products to its customers. In this climate, the Company must constantly change its product mix to sell to its customers. This requires the Company not only to design products which it anticipates will have commercial appeal, but also to develop, acquire and sometimes discontinue the use of In-House Branded Products and Licensed Products. -11- In 2003 the Company discontinued the marketing of products under the Rebecca Jones Label and commenced a long-term strategy of being a private label and licensed product business to expand its avenues of distribution. The Company acquired the use of Z. Cavaricci(R), Nicole Miller(R) and Bill Blass(R) Licenses for certain products. On October 1, 2003, the Company acquired its Robyn Meredith Division, which primarily sells Private Label Product. Sales under the Bill Blass(R) trademark and Robyn Meredith Division began in the second half of 2003. Sales under the Z. Cavaricci(R) trademark began in the first quarter of 2004. Sales for products under the Nicole Miller(R) trademarks for coats will begin in the Fall of 2004 and suits for the Spring 2005 season. In the three months ended June 30, 2004, the Company's net sales were $15.2 million of which 15% was Licensed Product, 30% was In-House Branded Product and the balance was Private Label Product. Net Sales for the second quarter of 2003 were $17.8 million, of which 50% was Licensed Product, 42% was In-House Branded Product and the balance was Private Label Product. The $2.6 million net sales decrease was attributable to a $6.6 million decrease in Licensed Products, due to the loss of a major customer and an inability to substitute the business with other customers, and a decrease in the In-House Branded Products of $2.8, partially offset by a $6.8 million increase in the sales of the Company's Private Label Products due to the acquisition of the Robyn Meredith business in 2003 and an increased demand for the Company's Private Label Products. Because of the challenges faced by the foregoing changing factors, the Company's management is constantly assessing the acceptance of its product mix and making adjustments accordingly. On April 14, 2004, the Company entered into a licensing agreement to manufacture sportswear under the Nicole Miller(R) label. The Company intends to begin shipments with the Spring 2005 season. In 2004, the Company embarked on a strategy to become a Branded and Private Label maker of Ladies Sportswear. To that end, the Company is discontinuing its In-House Brands and repositioning existing brands, which has caused a decrease in sales and a deterioration of its gross margin in 2004. The Company does not expect that this transformation will be complete until 2005, with the full effect to be reflected in the second half of 2005. The Company expects that the balance of 2004 may continue to be effected by this strategic transformation. In view of the strategy mentioned above, the Company has repositioned some of its current licenses and has acquired a new license to be used in Ladies better sportswear. The Company is in discussion with two major retailers to promote exclusive licensed products which would produce additional volume in 2005. While the Company is encouraged by these developments, there can be no assurances until orders are received. Comparison of Six Months Ended June 30, 2004 and 2003 Net sales increased by $2.0 million, or 5.4% from $36.8 million in the first six months of 2003 to $38.8 million in the first six months of 2004. The increase was primarily due to the Company's Private Label business as a result of the acquisition of the Robyn Meredith business in 2003, partially offset by decreases in the Company's other businesses due to the loss of a major customer and the strategy to discontinue In-House Brands. Gross profit for the first six months of 2004 was $6.9 million, or 17.8% of net sales, compared to $9.6 million, or 26.1% of net sales, during the first six months of 2003. The decrease in gross profit was due to the loss of a major customer, the strategy to discontinue In-House Brands and the sell off of slow moving inventory, which resulted in lower margins. -12- Selling, general and administrative expenses for the first six months of 2004 and 2003 were $10.5 million. Selling, general and administrative expenses in 2004 are net of a bad debt recovery in the second quarter of $0.8 million. In the first six months the Company incurred expenses in connection with its repositioning strategy, the results of which will not be seen until 2005. Net interest expense increased from $0.6 million during the first six months of 2003 to $1.0 million during the first six months of 2004. The increase was attributable to higher revolving credit borrowings under the credit agreement. In 2003, the Company had lower revolving credit borrowings and received interest from an income tax refund which decreased interest expense for the first quarter. In the first quarter of 2004, the Company reversed prior years' tax liabilities of approximately $0.2 million. Comparison of Quarters Ended June 30, 2004 and 2003 Net sales decreased by $2.6 million, or 14.6% from $17.8 million in the second quarter of 2003 to $15.2 million in the second quarter of 2004. The decrease was primarily due to the loss of a major customer and an inability to substitute the business with other customers, and the strategy to discontinue In-House Brands partially offset by increases in the Company's Private Label business as a result of the acquisition of the Robyn Meredith business. Gross profit for the second quarter of 2004 was $1.3 million, or 8.6% of net sales, compared to $3.9 million, or 21.9% of net sales, during the second quarter of 2003. The decrease in gross profit was due to the loss of a major customer, the strategy to discontinue In-House Brands and the sell off of slow moving inventory, which resulted in lower margins. Selling, general and administrative expenses for the second quarter of 2004 were $4.7 million compared to $5.1 million in the second quarter of 2003. The decrease in selling, general and administrative expenses was due in part to the recovery of a bad debt of $0.8 million. Net interest expense increased from $0.3 million during the first three months of 2003 to $0.5 million during the first three months of 2004. The increase was attributable to higher revolving credit borrowings under the credit agreement. New Licensing Agreements 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 began shipments with the Spring 2004 season. On September 10, 2003, the Company entered into a licensing arrangement to manufacture women's coats under various Nicole Miller labels. The Company intends to begin shipments with the Fall 2004 season. On March 8, 2004, the Company entered into a licensing agreement to manufacture women's suits under various Nicole Miller labels. The Company intends to begin shipments with the Spring 2005 season. On April 14, 2004, the Company entered into a licensing agreement to manufacture women's sportswear under various Nicole Miller labels. The Company intends to begin shipments with the Spring 2005 season. -13- 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 Credit Agreement (the "Credit Agreement") with CIT Group/Commercial Services (the "Lender"). The Credit Agreement initially 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 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 its 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 plans approved by the Lender. In July 2000, the Credit Agreement was amended to provide for an additional $1.3 million term loan to finance an acquisition. This term loan bore interest at the prime rate plus 2% through March 2003, at which time this term loan was paid. On March 28, 2001, the Company entered into an Amendment and Waiver Agreement to extend the Final Maturity Date of the original agreement to June 30, 2004, to waive existing events of default under the Credit Agreement as of December 31, 2000 with respect to the Company's non-compliance with covenants related to minimum interest coverage, EBITDA and Tangible Net Worth, and to amend certain other provisions of the Credit Agreement including covenants and the level of allowable overadvances to support the Company's 2001 business plan. Pursuant to this amendment, the interest rate on borrowings was increased to 2.0% above the prime rate effective January 1, 2001. A fee of $200,000 was paid in connection with the Amendment and Waiver. Effective January 1, 2002, the Company established covenants and the level of allowable overadvances with the Lender to support its 2002 business plan. This Amendment and Waiver Agreement also amended the interest rate on the revolving credit borrowings to the prime rate plus one and three quarters percent and provided for an additional interest rate reduction effective July 1, 2002 if certain objectives were achieved. No fee was paid in connection with the Amendment and Waiver. The Company achieved the objectives and received an additional rate reduction effective July 1, 2002. The interest rate on the revolving credit borrowings was prime plus one and one-half percent. -14- 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. No fee was paid in connection with the Amendment. Effective June 30, 2003, the Company through an Amendment and Waiver Agreement dated August 11, 2003, extended the Credit Agreement to June 30, 2007. This Amendment provides the Company with a $65 million facility; the sublimits have remained the same. The interest rate on the revolving credit borrowings is the current prime rate plus one and one-quarter percent (5.5% at June 30, 2004). Fees paid in connection with this Amendment were $243,750. All other terms and conditions of the Revolving Credit Agreement remained unchanged. As of December 31, 2003, the Company was not in compliance with the quarterly financial covenants of the Agreement. The Lender waived this non-compliance. The Company paid a fee of $100,000 in connection with this waiver. Effective January 1, 2004, the Company established covenants and the level of allowable overadvances with the Lender, through an Amendment to the Credit Agreement dated March 26, 2004, to support its 2004 business plan. No fee was paid in connection with this Amendment. As of June 30, 2004, the Company was not in compliance with the quarterly financial covenants. The Lender has waived this non- compliance. The Company paid a fee of $25,000 in connection with this waiver. The Company has recorded its obligation to the Lender as a current liability at June 30, 2004 since the Company projects that it will not be in compliance with its quarterly financial covenants over the next six months. 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 renews annually in June each year unless either party to the agreement gives appropriate notice of non-renewal. In connection with the acquisition of Robyn Meredith (see Note 9 to the Consolidated Financial Statements), a note payable of $1.1 million was issued. This note is payable in monthly installments of $33,333 including imputed interest at an interest rate of 5.25%. The final payment will be due October 2006. At June 30, 2004 and December 31, 2003, the Company was contingently liable for outstanding letters of credit issued amounting to $5.3 million and $6.6 million, respectively. During the first half of 2004, cash provided by operating activities was $5.1 million, principally as the result of decreases in amounts due from factor, accounts receivable and increases in accounts payable offset by increases in prepaid expenses and other current assets. On a comparable basis, net inventories at June 30, 2004 were $0.2 million more than at December 31, 2003. During the first half of 2003, cash provided by operating activities was $3.3 million, principally as the result of decreases in amounts due to from factor partially offset by increases in inventory, prepaid expenses and other current assets and by decreases in accounts payable and accrued expenses and other current liabilities. -15- Cash used in investing activities during the first half of 2004 was $0.6 million, mainly for leasehold improvements at the Company's New York showroom. Cash used in investing activities during the first half of 2003 included $0.6 million, for the purchase of fixed assets, principally computer equipment and related software and costs associated with the acquisition of a license. Cash used in financing activities during the first half of 2004 was $4.4 million, which represents net repayments under the revolver of $4.2 million and repayments of $0.2 million on a note payable. Cash used in financing activities during the first half of 2003 was $2.7 million, which represents net repayments under the revolver of $2.4 million and repayments of $0.3 million on the term loan. The Company is dependant upon the continued support of its Lender to fund its operations for the balance of the year and the future. Any change in the Lender's support could have an adverse effect on the Company's business and would cause the Company to seek alternative financing arrangements. The Company believes that with the support of its Lender and with cash flows from operations, the cash flow needs of the Company will be sufficient for the foreseeable future. Contractual Commitments and Contingent Liabilities The following table summarizes the Company's contractual commitments at June 30, 2004:

The Company has not provided any financial guarantees as of June 30, 2004. 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, 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 retailers and the tastes of the ultimate consumer up to a year prior to the relevant selling season. -16- 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. Principally, 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. 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. 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). The Company's cumulative net operating loss (NOL) carryforward of $20.0 million for federal income taxes and $31.0 million for state income taxes, have resulted in estimated tax benefits of $8.2 million as of December 31, 2003 being recorded as a deferred tax asset. The Company has recorded a valuation allowance against the entire net deferred tax assets balance due to 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 -17- 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. -18- 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 June 30, 2004 and December 31, 2003, 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 (5.5% at June 30, 2004). As of June 30, 2004, a hypothetical immediate 10% adverse change in prime interest rates (from 4.25% to 4.675%) 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 June 30, 2004, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. -19- 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. By Order dated May 4, 2004 based upon the case being settled, the action was dismissed. The Company is 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. (b) NONE -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: August 13, 2004 /s/ Daniel H. Levy ---------------------------------- Daniel H. Levy Chairman of the Board, Chief Executive Officer Date: August 13, 2004 /s/ Maureen d. Schimmenti ---------------------------------- Maureen d. Schimmenti Vice President and Chief Financial Officer, (Principal Financial Officer) -21-

DONNKENNY INC 10-Q