Ethan Allen Interiors 10-K 2006
Documents found in this filing:
Commission file number 1-11692
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [X] Yes [ ] No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. [ ] Yes [X] No
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. [X] Yes [ ] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Act). Large Accelerated Filer [X] Accelerated Filer [ ] Non-accelerated Filer [ ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). [ ] Yes [X] No
The aggregate market value of Common Stock, par value $.01 per share, held by non-affiliates (based upon the closing sale price on the New York Stock Exchange) on December 31, 2005, (the last day of the Companys most recently completed second fiscal quarter) was approximately $1,205,020,626. As of December 31, 2005, there were 32,987,151 shares of Common Stock, par value $.01 per share, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE: The definitive Proxy Statement for the 2006 Annual Shareholders Meeting is incorporated by reference into Part III hereof.
TABLE OF CONTENTS
Item 1. Business
Incorporated in Delaware in 1989, Ethan Allen Interiors Inc., through its wholly-owned subsidiary, Ethan Allen Global, Inc., and Ethan Allen Global, Inc.s subsidiaries (collectively, We, Us, Our, Ethan Allen or the Company), is a leading manufacturer and retailer of quality home furnishings and accessories, offering a full complement of home decorating and design solutions through one of the countrys largest home furnishing retail networks. In recent years, we have made, and continue to make, considerable investment in our business in order to expand and improve our interior design capabilities. In order to better reflect these expanded capabilities, we have changed the designation of our Ethan Allen retail outlets from stores to interior design centers (IDCs). The Company was founded in 1932 and has sold products under the Ethan Allen brand name since 1937.
Our primary business objective is to be a leader in style, providing our customers with a convenient, full-service, one-stop shopping solution for their home decorating needs. In order to meet our stated objective, we have developed and adhere to a focused and comprehensive business strategy. The elements of this strategy, each of which is integral to our solutions-based philosophy, include (i) our vertically integrated operating structure, (ii) our products and related marketing initiatives, (iii) our retail IDC network, (iv) our people, and (v) our numerous customer service offerings.
Our operations are classified into two operating segments: wholesale and retail. These operating segments represent strategic business areas which, although they operate separately and provide their own distinctive services, enable us to more effectively offer our complete line of home furnishings. See Note 16 to the Consolidated Financial Statements included under Item 8 of this Annual Report for certain financial information regarding our operating segments.
The wholesale segment is principally involved in the development of the Ethan Allen brand, which encompasses the design, manufacture, domestic and off-shore sourcing, sale and distribution of a full range of home furnishings to a network of independently-owned and Ethan Allen-owned IDCs as well as related marketing and brand awareness efforts. Wholesale revenue is generated upon the wholesale sale of our product to all retail IDCs, including those owned by Ethan Allen. Wholesale profitability includes (i) the wholesale gross margin, which represents the difference between the wholesale sales price and the cost associated with manufacturing and/or sourcing the related product, and (ii) other operating costs associated with wholesale segment activities.
The retail segment sells home furnishings to consumers through a network of Company-owned IDCs. Retail revenue is generated upon the retail sale of our products by these IDCs. Retail profitability includes (i) the retail gross margin, which represents the difference between the retail sales price and the cost of goods purchased from the wholesale segment, and (ii) other operating costs associated with retail segment activities.
While the manner in which our home furnishings are marketed and sold is consistent, the nature of the underlying recorded sales (i.e. wholesale versus retail) and the specific services that each operating segment provides (i.e. wholesale manufacturing, sourcing, and distribution versus retail selling) are different. Within the wholesale segment, we maintain revenue information according to each respective product line (i.e. case goods, upholstery, or home accessories and other). Sales of case good items include, but are not limited to, beds, dressers, armoires, night tables, dining room chairs and tables, buffets, sideboards, coffee tables, entertainment units, bathroom vanities and home office furniture. Sales of upholstery home furnishing items include sleepers, recliners, chairs, sofas, loveseats, cut fabrics and leather. Skilled craftsmen cut, sew and upholster custom-
designed upholstery items which are available in a variety of frame and fabric options. Home accessory and other items include window treatments, wall decor, lighting, clocks, wood accents, bedspreads, decorative accessories, area rugs, bedding, and home and garden furnishings.
Revenue information by product line is not as easily determined within the retail segment. However, because wholesale production and sales are matched, for the most part, to incoming orders, we believe that the allocation of retail sales by product line would be similar to that of the wholesale segment.
We evaluate performance of the respective segments based upon revenues and operating income. Inter-segment eliminations result, primarily, from the wholesale sale of inventory to the retail segment, including the related profit margin.
In fiscal 2006, wholesale sales to independent retailers and retail sales of Company-owned IDCs accounted for approximately 35% and 65%, respectively, of our total net sales.
Wholesale net sales for each of the last three fiscal years, allocated by product line, were as follows:
We operate 11 manufacturing facilities, including 5 case good plants (2 of which include separate sawmill operations), 5 upholstery plants and 1 home accessory plant, all located in the United States. We also source selected case good, upholstery, and home accessory items from third-party vendors located both domestically and abroad.
As of June 30, 2006, we maintained a wholesale backlog of $37.4 million (as compared to $49.3 million as of June 30, 2005) which is anticipated to be serviced in the first quarter of fiscal 2007. Backlog at any point in time is a result, primarily, of net orders booked in prior periods, manufacturing schedules, timing associated with the receipt of sourced product, and the timing and volume of wholesale shipments.
For the twelve months ended June 30, 2006, net orders booked at the wholesale level, which includes orders generated by independently-owned and Company-owned IDCs, totaled $733.6 million as compared to $670.6 million for the twelve months ended June 30, 2005. Net orders booked in any period are recorded based on wholesale prices and do not reflect the additional retail margins produced by Company-owned IDCs.
Retail Segment Overview:
We sell our products through an exclusive network of 306 retail IDCs. As of June 30, 2006, we owned and operated 139 IDCs and independent retailers owned and operated 167 IDCs (as compared to 126 and 187, respectively, at the end of the prior fiscal year). The ten largest independent retailers own a total of 38 IDCs, which, based on net orders booked, accounted for approximately 13% of total net sales in fiscal 2006.
During fiscal 2006, we acquired 12 IDCs from independent retailers, opened 8 new IDCs (of which 6 were relocations), and closed 1 IDC. In addition, during the past year, independent retailers opened 8 new IDCs (of which 3 were relocations). In the past five years, we and our independent retailers have combined to open 77 new IDCs, approximately 48% of which were relocations. The geographic distribution of all retail IDC locations is included under Item 2 of Part I of this Annual Report.
We pursue further expansion of the Company-owned retail business by opening new IDCs, relocating existing IDCs and, when appropriate, acquiring IDCs from independent retailers. In addition, we continue to promote the growth of our independent retailers through ongoing support in the areas of market analysis, site selection, and business development. All retailers are required to enter into license agreements with us which (i) authorize the use of certain Ethan Allen service marks and (ii) require adherence to certain standards of operation, including the exclusive sale of our products and a requirement to fulfill related warranty service agreements. We are not subject to any territorial or exclusive retailer agreements in the United States.
In October 2001, we formed a joint venture with MFI Furniture Group, Plc to open a network of retail IDCs in the United Kingdom. The initial phase of the agreement called for the two companies to collaborate on the development of a retail IDC format that would market their respective retail concepts, allowing for the opening of up to five IDCs totaling approximately 8,000 to 15,000 square feet per location. In December 2005, both parties mutually agreed to dissolve the joint venture and, as of June 30, 2006, the joint venture had been terminated.
Our product strategy has been to position our brand as a preferred brand with superior quality and value while, at the same time, providing consumers with a comprehensive, one-stop shopping solution for their home furnishing needs. In carrying out our strategy, we continue to expand our reach to a broader consumer base through a diverse selection of attractively priced product lines, many of which have been designed to effectively complement one another, reflecting the recent trend toward more eclectic home decorating. In recent years, this effort is best evidenced by the introduction of collections such as Townhouse, Tuscany, Newport, New Country by Ethan Allen, Tango and, most recently, Maison by Ethan Allen and American Classics by Ethan Allen. These collections, as well as increased styles and fabric selections within our custom upholstery line, new finishes within our Horizons line, the redesign of our American Impressions line (renamed New Impressions), and expanded product offerings to accommodate todays home theater trends, are serving to redefine Ethan Allen, positioning us as a leader in style. All of these product lines, each of which broadens our consumer reach, are reflective of our continuing efforts to offer well valued, stylish home furnishings that appeal to a variety of customers and lifestyles.
We believe that the two most important style categories in home furnishings are the Classic and the Casual lifestyles. As such, our collections are designed to reflect unique elements applicable to each lifestyle. To accomplish this, our collections consist of case goods, coordinated upholstered products and home accessories, each styled with our own distinct design characteristics. Home accessories play an important role in our marketing program as they enable us to offer the consumer the convenience of one-stop shopping by creating a comprehensive home furnishing solution. The interior of our IDCs is designed to facilitate display of our product offerings in complete room settings, utilizing the related collections to project the category lifestyle.
We continuously monitor changes in home design trends through attendance at international industry events and fashion shows, internal market research, and regular communication with our retailers and IDC design consultants who provide valuable input on consumer tendencies. Observations and input gathered as a result of
our efforts enable us to incorporate appropriate style details into our products thereby allowing us, we believe, to react quickly to changing consumer tastes. For example, since 2002, approximately 70% of our current complement of collections is new. The balance has been refined and enhanced through product redesign, additions, deletions, and/or finish changes. Such undertakings are indicative of our ability to adapt to the current consumer trend toward more casual and eclectic lifestyles while, at the same time, maintaining a classic appeal.
In fiscal 2005, we also introduced an innovative pricing program, eliminating periodic sale events in lieu of an everyday best price on all of our product offerings. We believe that this initiative demonstrates our commitment to differentiating ourselves through strategies focused on customer credibility and excellence in service. In addition, everyday best pricing provided us the opportunity to critically examine all facets of our business, making substantive changes, where necessary, in order to more effectively carry out our solutions-based approach to home decorating.
Product Sourcing Activities
We are one of the largest manufacturers of home furnishings in the United States, currently manufacturing and/or assembling approximately 60-65% of our products within 11 manufacturing facilities, 2 of which include separate sawmill operations. The balance of our production is outsourced, according to our own internally-developed design specifications, through third-party vendors, most of which are located abroad. Our case good facilities are located close to sources of raw materials and skilled craftsmen, predominantly in the Northeast and Southeast regions of the country. Upholstery facilities are located across the country in order to reduce shipping costs to retail IDCs and are situated where skilled craftsmen are available. We believe that continued investment in our manufacturing facilities, combined with an appropriate level of outsourcing through both foreign and domestic vendors, will accommodate future sales growth and allow us to maintain an appropriate degree of control over cost, quality and service to our customers.
Raw Materials and Other Suppliers
The most important raw materials used by us in furniture manufacturing are lumber, veneers, plywood, hardware, glue, finishing materials, glass, mirrored glass, laminates, fabrics, foam, and filling material. The various types of wood used in our products include cherry, ash, oak, maple, prima vera, mahogany, birch and pine, substantially all of which are purchased domestically.
Fabrics and other raw materials are purchased both domestically and abroad. We have no significant long-term supply contracts, and have experienced no significant problems in supplying our operations. We maintain a number of sources for our raw materials which, we believe, contributes to our ability to obtain competitive pricing. Lumber prices fluctuate over time based on factors such as weather and demand, which, in turn, impact availability. Upward trends in prices could have an adverse effect on margins.
Appropriate amounts of lumber and fabric inventory are typically stocked so as to maintain adequate production levels. We believe that our sources of supply for these materials are sufficient and that we are not dependent on any one supplier.
We enter into standard purchase agreements with certain foreign and domestic vendors to source selected case good, upholstery, and home accessory items. The terms of these arrangements are customary for the industry and do not contain any long-term contractual obligations on our behalf. We believe we maintain good relationships with our vendors.
Distribution and Logistics
Within the wholesale segment, we warehouse and distribute our products primarily through a national network of 7 owned and 3 leased distribution centers strategically located throughout the United States. Additionally, we
are currently in the process of converting one of our former manufacturing facilities into a regional distribution center. These distribution centers hold finished product received from our manufacturing facilities and our third-party vendors, for shipment to retail IDCs and retail service centers. From time to time, we may also rent temporary warehouse space and/or utilize third-party logistics service providers to accommodate our additional storage needs. We stock selected case goods and accessories to provide for quick delivery of in-stock items and to allow for more efficient production runs.
Wholesale shipments are made utilizing our own fleet of trucks and trailers or through subcontracting agreements with independent carriers. Approximately 43% of our fleet (trucks and trailers) is leased under two to seven-year leases.
Our policy is to sell our products at the same delivered cost to all Company-owned and independently-owned IDCs nationwide, regardless of their shipping point. The adoption of this policy has created pricing credibility and eliminated the need for our independent retailers to carry significant amounts of inventory in their own warehouses. As a result, we obtain more accurate information regarding product demand in order to better plan production runs and manage inventory levels.
We believe that our ability to coordinate advertising efforts for all Ethan Allen branded IDCs, including, from time to time, coordination of local market advertising, provides a competitive advantage over other home furnishing manufacturers and retailers. With an exclusive network of more than 300 retail IDCs adhering to a uniform marketing approach and speaking with one voice, we believe we are better positioned to fulfill our brand promise on a consistent basis.
In support of our marketing campaign, television (both national and local), direct mail, newspapers, magazines, radio, and our internet website continue to be utilized to promote our products and services. In addition, during fiscal 2006, we introduced a national email marketing campaign which serves to distribute, every other week, electronic newsletters containing inspirational interior design ideas to a growing database of consumers.
Our national television advertising campaign is designed to communicate our position as both a leader in style and a full-service provider of home decorating and design solutions, and to drive qualified traffic into the retail IDC network. Our in-house staff, working with a leading advertising firm, has developed and implemented what we believe to be the most cohesive national television advertising campaign in the home furnishings industry. Coordinated local television advertising serves to support our national television program and allows us, we believe, to capitalize on our existing brand equity and maintain top-of-mind awareness of the breadth of our product and service offerings.
The Ethan Allen direct mail magazine, which features our home furnishing collections in lifestyle settings and communicates the breadth of our services, is one of our most important marketing tools. We publish and sell the magazines to both Company-owned and independently-owned IDCs, who, with demographic information collected through independent market research, are able to target potential customers. Given the importance of this advertising medium, direct mail marketing lists continue to be refined in order to target those consumers that are most likely to purchase, with the objective of improving our return on direct mail expenditures. Approximately 37 million copies of our direct mail magazine were distributed to consumers during fiscal 2006.
Our television advertising and direct mail efforts are supported by strong print and radio campaigns in various markets, along with other public relations efforts. During fiscal 2006, we also created a publication entitled Ethan Allen Style. This 320-page book, which includes a complete catalogue of our home furnishing collections, helps customers identify their own personal style using our product offerings. We believe this publication represents one of the most comprehensive and effective home decorating resources in the home furnishings industry.
We are located on the worldwide web at www.ethanallen.com. The primary goal of our website is to drive additional business into the retail IDC network through lead generation and information sourcing. With this is mind, customers may access our website to review home furnishing collections or to purchase selected home accessories.
We have also developed an extranet website which links the retail IDCs with consumer information captured on-line, such as customer requests for design assistance and copies of our catalogue. This medium has become the primary source of communications within our retail network providing a variety of information, including a Company-wide daily news flash, downloads of current advertising materials, prototype IDC display floor plans and detailed product information.
Retail IDC Network
Ethan Allen IDCs are typically located in busy urban settings as freestanding destinations or as part of suburban strip malls, depending upon the real estate opportunities in a particular market. Currently, IDCs range in size from approximately 6,000 square feet to 35,000 square feet, with the average size being approximately 15,000 square feet.
We maximize uniformity of presentation throughout the retail IDC network through a comprehensive set of standards. These standards assist each IDC in presenting the same high quality image and offer retail customers consistent levels of product selection and service. A uniform IDC image is conveyed through our ongoing program to model all retail IDCs with similar and consistent exterior facades and interior layouts. This program is carried out at all IDCs, including those that are independently-owned and operated.
We provide display planning assistance to all Company-owned IDCs and independent retailers to support them in updating the interior projection and to maintain a consistent image. We have developed a standard interior design format for our retail network which, through the use of focused lifestyle settings to display our products and information displays to educate consumers, has positioned Ethan Allen as a specialist in Classic and Casual lifestyles and decorative accessory retailing.
At June 30, 2006, we had approximately 6,400 employees, approximately 5% of which are represented by unions under collective bargaining agreements. Most of these collective bargaining agreements expire at various times throughout the next three years. We expect no significant changes in our relations with these unions and believe we maintain good relationships with our employees.
The retail network, which includes both Company-owned and independently-owned IDCs, is staffed with a sales force of more than 3,000 design consultants and service professionals who provide customers with an effective home decorating solution at no additional charge. Our employees receive appropriate training with respect to the distinctive design and quality features inherent in each of our products, allowing them to more effectively communicate the elements of style and value that serve to differentiate us from the competition. As such, we believe our design consultants, and the complimentary service they provide, create a distinct competitive advantage over other home furnishing retailers.
During the past year, we have made considerable investment within the retail network to strengthen the existing management structure. Implementation of our project management initiative, which resulted in the promotion and/or hiring of approximately 200 project managers, has enabled us to increase the level of service, professionalism, interior design competence, efficiency, and effectiveness of retail IDC personnel. With project managers actively partnering with design consultants and their customers, we believe we have improved the customer service experience and facilitated, to some degree, better awareness of potential cross-selling opportunities.
We recognize the importance of our retail IDC network to our long-term success. Accordingly, we believe we have established strong management teams within Company-owned IDCs while, at the same time, maintaining effective relationships with independent retailers. With this in mind, we make our services available to every IDC, whether independently-owned or Company-owned, in support of their marketing efforts, including coordinated advertising, merchandising and display programs, and extensive training seminars and educational materials. We believe that the development of project managers, design consultants, service and delivery personnel, and retailers is important for the growth of our business. As a result, we have committed to make available a comprehensive retail training program which is intended to increase the customer service capabilities of each individual.
Customer Service Offerings
We offer numerous customer service programs, each of which has been developed and introduced to consumers in an effort to make their shopping experience easier and more enjoyable.
On-Line Room Planning
Ethan Allen Consumer Credit Programs
In recent years, the home furnishings industry has faced numerous challenges, not the least of which is an influx of low-priced competition from overseas and some resultant measure of price deflation. As a result, we believe a trend toward product commoditization has developed. In that time, we have, instead, attempted to further differentiate ourselves as a preferred brand by adhering to a business strategy focused on providing (i) high-quality products at good value, including the marketing of our products at an everyday best price, (ii) a comprehensive complement of home furnishing design solutions, including our complimentary design service, and (iii) excellence in customer service. We consider our vertical integration a significant competitive advantage in the current environment as it allows us to design, manufacture, source, distribute, market, and sell our products through one of the industrys largest sole-source retail networks.
Industry globalization has provided us an opportunity to introduce selected products to consumers at prices that, until recently, were not practical. As such, we continue to adhere to a blended strategy, establishing relationships with certain manufacturers, both domestically and abroad, to source selected case goods, upholstery, and home accessory items. We intend to continue to balance our domestic production with opportunities to source from foreign and domestic manufacturers, as appropriate, in order to maintain our competitive advantage.
We believe the home furnishings industry competes primarily on the basis of product styling and quality, personal service, prompt delivery, product availability and price. We further believe that we effectively compete on the basis of each of these factors and that, more specifically, our retail format and complimentary design service create a distinct competitive advantage, further supporting our mission of providing consumers with a complete home decorating and design solution. Our objective is to continue to develop and strengthen our retail network by (i) expanding the Company-owned retail business through the opening of new IDCs, relocating existing IDCs and, when appropriate, acquiring IDCs from, or selling IDCs to, independent retailers, and (ii) obtaining and retaining independent retailers, assisting such retailers in expanding their business through the opening or relocation of new IDCs and increasing the volume of their sales.
We currently hold, or have registration applications pending for, numerous trademarks, service marks and design patents for the Ethan Allen name, logos and designs in a broad range of classes for both products and services in the United States and in many foreign countries. In addition, we have registered, or have applications pending for, many of our major collection names as well as certain of our slogans utilized in connection with promoting brand awareness, retail sales and other services. We view such trade and service marks as valuable assets and have an ongoing program to diligently monitor and defend, through appropriate action, against their unauthorized use.
We make available, free of charge via our website, all Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other information filed with, or furnished to, the Securities and Exchange Commission (SEC), including amendments to such reports. This information is available at www.ethanallen.com/investors as soon as reasonably practicable after it is electronically filed with, or furnished to, the SEC.
In addition, charters of all committees of our Board of Directors, as well as our Corporate Governance guidelines, are available on our website at www.ethanallen.com/governance or, upon written request, in printed hardcopy form. Written requests should be sent to Office of the Secretary, Ethan Allen Interiors Inc., Ethan Allen Drive, Danbury, Connecticut 06811.
Item 1A. Risk Factors
The following information describes certain significant risks and uncertainties inherent in our business that should be carefully considered, along with other information contained elsewhere in this report and in other filings, when making an investment decision with respect to us. If one or more of these risks actually occurs, the impact on our business, including our financial condition, results of operations, and cash flows could be adversely affected.
We face changes in global
and local economic conditions that may adversely affect consumer demand and spending, our
Historically, the home furnishings industry has been subject to cyclical variations in the general economy and to uncertainty regarding future economic prospects. We are currently confronted with the risk of increased expenses and decreased demand from customers as a result of recent natural disasters and other unfavorable weather conditions, the war in Iraq, armed conflicts and terrorist attacks. These global uncertainties, as well as other variations in global economic conditions such as rising fuel costs and increasing interest rates, may continue to cause inconsistent and unpredictable consumer spending habits, while increasing our own fuel, utility, transportation or security costs. These risks, as well as industrial accidents or work stoppages, could also severely disrupt our manufacturing operations, which could have a material adverse effect on our financial performance.
We import a portion of our merchandise from foreign countries. As a result, our costs may be increased by events affecting international commerce and businesses located abroad, including changes in international trade, central bank actions and other governmental policies of the U.S. and the countries from which we import a portion of our merchandise. The inability to import products from certain foreign countries or the imposition of significant tariffs could have a material adverse effect on our results of operations.
Competition from overseas manufacturers continues to increase and may adversely affect our business, operating results or financial condition.
Our wholesale business segment is involved in the development of our brand, which encompasses the design, manufacture, sourcing, sales and distribution of our home furnishings products, and competes with other U.S. and foreign manufacturers. Our retail business segment sells home furnishings to consumers through a network of Company-owned IDCs, and competes against a diverse group of retailers ranging from specialty stores to traditional furniture and department stores, any of which may operate locally, regionally and nationally. We also compete with these and other retailers for appropriate retail locations as well as for qualified design consultants and management personnel. Such competition could adversely affect our future financial performance.
Industry globalization has led to increased competitive pressures brought about by the increasing volume of imported finished goods and components, particularly for case good products, and the development of manufacturing capabilities in other countries, specifically within Asia. The increase in overseas production capacity in recent years has created over-capacity for many U.S. manufacturers, including us, which has led to industry-wide plant consolidation. In addition, because many foreign manufacturers are able to maintain substantially lower production costs, including the cost of labor and overhead, imported product may be capable of being sold at a lower price to consumers, which, in turn, could lead to some measure of industry-wide price deflation.
We cannot provide assurance that we will be able to establish or maintain relationships with certain manufacturers, either abroad or domestically, to supply us with selected case goods, upholstery and home accessory items to enable us to maintain our competitive advantage. In addition, the recent emergence of foreign manufacturers has served to broaden the competitive landscape. Some of these competitors produce furniture types not manufactured by us and may have greater financial and other resources available to them. This competition could adversely affect our future financial performance.
Failure to successfully anticipate or respond to changes in consumer tastes and trends in a timely manner could adversely impact our business, operating results and financial condition.
Sales of our products are dependent upon consumer acceptance of our product designs, styles, quality and price. We continuously monitor changes in home design trends through attendance at international industry events and fashion shows, internal marketing research, and regular communication with our retailers and IDC design consultants who provide valuable input on consumer tendencies. However, as with all retailers, our business is susceptible to changes in consumer tastes and trends. Such tastes and trends can change rapidly and any delay or failure to anticipate or respond to changing consumer tastes and trends in a timely manner could adversely impact our business, operating results and financial condition.
Fluctuations in the price, availability and quality of raw materials could result in increased costs or cause production delays which might result in a decline in sales, either of which could adversely impact our earnings.
We use various types of wood, foam, fibers, fabrics, leathers, and other raw materials in manufacturing our furniture. Certain of our raw materials, including fabrics, are purchased both abroad and domestically. Fluctuations in the price, availability and quality of raw materials could result in increased costs or a delay in manufacturing our products, which in turn could result in a delay in delivering products to our customers. For example, lumber prices fluctuate over time based on factors such as weather and demand, which in turn, impact availability. Production delays or upward trends in raw material prices could result in lower sales or margins, thereby adversely impacting our earnings.
In addition, certain suppliers may require extensive advance notice of our requirements in order to produce products in the quantities we desire. This long lead time may require us to place orders far in advance of the time when certain products will be offered for sale, thereby exposing us to risks relating to shifts in consumer demand and trends, and any downturn in the U.S. economy.
Our business is sensitive to increasing labor costs, competitive labor markets, our continued ability to retain high-quality personnel and risks of work stoppages.
The market for qualified employees and personnel in the retail and manufacturing industries is highly competitive. Our success depends upon our ability to attract, retain and motivate qualified craftsmen, management, marketing and sales personnel and upon the continued contributions of these individuals. We cannot provide assurance that we will be successful in attracting and retaining qualified personnel. A shortage of qualified personnel may require us to enhance our wage and benefits package in order to compete effectively in the hiring and retention of qualified employees. Our labor costs may continue to increase and such increases may not be recovered. In addition, some of our employees are covered by collective bargaining agreements with local labor unions. Although we do not anticipate any difficulty renegotiating these contracts as they expire, a labor-related stoppage by these unionized employees could adversely affect our business and results of operations. The loss of the services of key personnel or our failure to attract additional qualified personnel could have a material adverse effect on our business, operating results and financial condition.
Our success depends upon our brand, marketing and advertising efforts and pricing strategies, and if we are not able to maintain and enhance our brand, or if we are not successful in these efforts, our business and operating results could be adversely affected.
Maintaining and enhancing our brand is critical to our ability to expand our base of customers and may require us to make substantial investments. Our advertising campaign utilizes television, direct mail, newspapers, magazines and radio to maintain and enhance our existing brand equity. We cannot provide assurance that our marketing, advertising and other efforts to promote and maintain awareness of our brand will not require us to incur substantial costs. If these efforts are unsuccessful or we incur substantial costs in connection with these efforts, our business, operating results and financial condition could be adversely affected.
We may not be able to maintain our current IDC locations at current costs. We may also fail to successfully select and secure IDC locations.
Our IDCs are typically located in busy urban settings as freestanding destinations or as part of suburban strip malls, depending upon the real estate opportunities in a particular market. Our business competes with other retailers and as a result, our success may be affected by our ability to renew current IDC leases and to select and secure appropriate retail locations for existing and future IDCs.
We depend on key personnel and could be affected by the loss of their services.
The success of our business depends upon the services of certain senior executives, and in particular, the services of M. Farooq Kathwari, Chairman of the Board, President and Chief Executive Officer, who is the only one of our senior executives who operates under a written employment agreement. The loss of any such person or other key personnel could have a material adverse effect on our business and results of operations.
As we expand and grow our business, we may rely on external funding sources to finance our operations and growth.
Historically, we have relied upon our cash from operations to fund our operations and growth. As we expand our business, we may rely on external funding sources, including the proceeds from the issuance of debt or the $200 million revolving bank line of credit available under our existing credit facility. Any unexpected reduction in cash flow from operations could increase our external funding requirements to levels above those currently available. There can be no assurance that we will not experience unexpected cash flow shortfalls in the future or that any increase in external funding required by such shortfalls will be available.
Our results of operations for any quarter are not necessarily indicative of our results of operations for a full year.
Sales of furniture and other home furnishing products fluctuate from quarter to quarter due to such factors as changes in global and regional economic conditions, changes in competitive conditions, changes in production schedules in response to seasonal changes in energy costs and weather conditions, and changes in consumer order patterns. From time to time, we have experienced, and may continue to experience, volatility with respect to demand for our home furnishing products. Accordingly, results of operations for any quarter are not necessarily indicative of the results of operations for a full year.
Our current and former manufacturing operations are subject to increasingly stringent environmental, health and safety requirements.
We use and generate hazardous substances in our manufacturing and retail operations. In addition, both the manufacturing properties on which we currently operate and those on which we have ceased operations are and have been used for industrial purposes. Our manufacturing operations and, to a lesser extent, our retail operations involve risk of personal injury or death. We are subject to increasingly stringent environmental, health and safety laws and regulations relating to our current and former properties and our current operations. These laws and regulations provide for substantial fines and criminal sanctions for violations and sometimes require the installation of costly pollution control or safety equipment or costly changes in operations to limit pollution or decrease the likelihood of injuries. In addition, we may become subject to potentially material liabilities for the investigation and cleanup of contaminated properties and to claims alleging personal injury or property damage resulting from exposure to or releases of hazardous substances or personal injury as a result of an unsafe workplace. We have been identified as a potentially responsible party in connection with five sites that are currently listed, or proposed for inclusion, on the National Priorities List under the Comprehensive Environmental Response, Compensation and Liability Act or its state counterpart. In addition, noncompliance with, or stricter enforcement of, existing laws and regulations, adoption of more stringent new laws and
regulations, discovery of previously unknown contamination or imposition of new or increased requirements could require us to incur costs or become the basis of new or increased liabilities that could be material.
Failure to protect our intellectual property could adversely affect us.
We believe that our patents, trademarks, service marks, trade secrets, copyrights and all of our other intellectual property are important to our success. We rely on patent, trademark, copyright and trade secret laws, and confidentiality and restricted use agreements, to protect our intellectual property and may seek licenses to intellectual property of others. Some of our intellectual property is not covered by any patent, trademark, or copyright or any applications for the same. We cannot provide assurance that agreements designed to protect our intellectual property will not be breached, that we will have adequate remedies for any such breach, or that the efforts we take to protect our proprietary rights will be sufficient or effective. Any significant impairment of our intellectual property rights or failure to obtain licenses of intellectual property from third parties could harm our business or our ability to compete. Moreover, we cannot provide assurance that the use of our technology or proprietary know-how or information does not infringe the intellectual property rights of others. If we have to litigate to protect or defend any of our rights, such litigation could result in significant expense.
Item 1B. Unresolved Staff Comments
Item 2. Properties
Our corporate headquarters, located in Danbury, Connecticut, consists of one building containing 144,000 square feet, situated on approximately 18.0 acres of land, all of which is owned by us. Located adjacent to the corporate headquarters, and situated on approximately 5.4 acres, is the Ethan Allen Hotel and Conference Center, containing 195 guestrooms. This hotel, owned by a wholly-owned subsidiary of Ethan Allen, is used in connection with Ethan Allen functions and training programs, as well as for functions and accommodations for the general public.
We have 11 manufacturing facilities located in 6 states. All of these facilities are owned, with the exception of a leased upholstery plant in California, totaling 145,636 square feet. Our 11 facilities consist of 5 case good manufacturing plants (2 of which include separate sawmill operations), totaling 1,811,187 square feet; 5 upholstery furniture plants (including the leased space in California), totaling 1,234,136 square feet; and 1 plant involved in the manufacture and assembly of our home accessory products, totaling 295,000 square feet.
In addition, we own 7 and lease 3 ancillary distribution centers, totaling 1,173,370 square feet. We are currently in the process of converting one of our former manufacturing facilities, located in Dublin, Virginia and totaling approximately 600,000 square feet, into a regional distribution center. This property, which is owned by us, is expected to become fully operational as a distribution center in September 2006. Our manufacturing and distribution facilities are located in North Carolina, Vermont, Pennsylvania, Virginia, Oklahoma, California, New Jersey, Indiana, Illinois and Maine.
We own 3 and lease 29 retail service centers, totaling 1,270,422 square feet. Our retail service centers are located throughout the United States and serve to support our various sales districts. The geographic distribution of our retail IDC network as of June 30, 2006 is as follows:
Of the 139 retail IDCs owned and operated by us, 54 of the properties are owned and 85 of the properties are leased from independent third parties. Of the 54 Company-owned IDC locations, 12 are subject to land leases. We own an additional 5 retail properties: 4 of which are leased to independent Ethan Allen retailers, and 1 of which is leased to an unaffiliated third party.
Our manufacturing facility located in Maiden, North Carolina and the Ethan Allen Hotel and Conference Center located in Danbury, Connecticut, were financed, in part, with industrial revenue bonds. The bonds associated with the Maiden facility matured in October 2004 and were repaid in full at that time. The bonds associated with the Ethan Allen Hotel and Conference Center bear interest at a fixed rate of 7.50% and have a remaining maturity of 5 years. The Beecher Falls, Vermont manufacturing facility was financed, in part, by the State of Vermont Economic Development Authority (VEDA) and the Town of Canaan, Vermont. The VEDA debt matured in June 2006 and was repaid in full at that time. The Town of Canaan debt bears interest at a fixed rate of 3.00% and has a remaining maturity of 5-20 years. We believe that all of our properties are well maintained and in good condition.
We estimate that our manufacturing division is currently operating at approximately 80% of capacity. We believe we have additional capacity at selected facilities, which we could utilize with minimal additional capital expenditures.
Item 3. Legal Proceedings
We are a party to various legal actions with customers, employees and others arising in the normal course of our business. We maintain liability insurance, which is deemed to be adequate for our needs and commensurate with other companies in the home furnishings industry. We believe that the final resolution of pending actions (including any potential liability not fully covered by insurance) will not have a material adverse effect on our financial condition, results of operations, or cash flows.
We and our subsidiaries are subject to various environmental laws and regulations. Under these laws, we and/or our subsidiaries are, or may be, required to remove or mitigate the effects on the environment of the disposal or release of certain hazardous materials.
As of June 30, 2006, we and/or our subsidiaries have been named as a potentially responsible party (PRP) with respect to the remediation of four active sites currently listed, or proposed for inclusion, on the National Priorities List (NPL) under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended, (CERCLA). The sites are located in Lyndonville, Vermont; Southington, Connecticut; High Point, North Carolina; and Atlanta, Georgia.
With respect to the Lyndonville, Vermont site, we have substantially resolved our liability by completing remedial construction activities. We continue to work with the U.S. Environmental Protection Agency (EPA) and have obtained a certificate of construction completion, subject to certain limited conditions. We do not anticipate incurring significant costs with respect to the Southington, Connecticut, High Point, North Carolina, or Atlanta, Georgia sites as we believe that we are not a major contributor based on the very small volume of waste generated by us in relation to total volume at those sites. Specifically, with respect to the Southington site, our volumetric share is less than 1% of over 51 million gallons disposed of at the site and there are more than 1,000 PRPs. With respect to the High Point site, our volumetric share is less than 1% of over 18 million gallons disposed of at the site and there are more than 2,000 PRPs, including 1,100 de-minimis parties (of which we are one). With respect to the Atlanta site, a former solvent recycling/reclamation facility, our volumetric share is less than 1% of over 20 million gallons disposed of at the site by more than 1,700 PRPs. In all three cases, the other PRPs consist of local, regional, national and multi-national companies.
Liability under CERCLA may be joint and several. As such, to the extent certain named PRPs are unable, or unwilling, to accept responsibility and pay their apportioned costs, we could be required to pay in excess of our pro rata share of incurred remediation costs. Our understanding of the financial strength of other PRPs has been considered, where appropriate, in the determination of our estimated liability.
In addition, in July 2000, we were notified by the State of New York (the State) that we may be named a PRP in a separate, unrelated matter with respect to a site located in Carroll, New York. To date, no further notice has been received from the State and an initial environmental study has not yet been conducted at this site.
As of June 30, 2006, we believe that established reserves related to these environmental contingencies are adequate to cover probable and reasonably estimable costs associated with the remediation and restoration of these sites.
We are subject to other federal, state and local environmental protection laws and regulations and are involved, from time to time, in investigations and proceedings regarding environmental matters. Such investigations and proceedings typically concern air emissions, water discharges, and/or management of solid and hazardous wastes. We believe that our facilities are in material compliance with all such applicable laws and regulations.
Regulations issued under the Clean Air Act Amendments of 1990 required the industry to reformulate certain furniture finishes or institute process changes to reduce emissions of volatile organic compounds. Compliance with many of these requirements has been facilitated through the introduction of high solids coating technology and alternative formulations. In addition, we have instituted a variety of technical and procedural controls, including reformulation of finishing materials to reduce toxicity, implementation of high velocity low pressure spray systems, development of storm water protection plans and controls, and further development of related inspection/audit teams, all of which have served to reduce emissions per unit of production. We remain committed to implementing new waste minimization programs and/or enhancing existing programs with the objective of (i) reducing the total volume of waste, (ii) limiting the liability associated with waste disposal, and (iii) continuously improving environmental and job safety programs on the factory floor which serve to minimize emissions and safety risks for employees. We will continue to evaluate the most appropriate, cost effective, control technologies for finishing operations and design production methods to reduce the use of hazardous materials in the manufacturing process.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to our security holders during the fourth quarter of fiscal 2006.
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is traded on the New York Stock Exchange under ticker symbol ETH. The following table indicates (i) the high and low stock prices as reported on the New York Stock Exchange and (ii) dividends declared by us:
As of September 11, 2006, there were 369 shareholders of record of our Common Stock.
On July 25, 2006, we declared a dividend of $0.20 per common share, payable on October 25, 2006 to shareholders of record as of October 10, 2006. We expect to continue to declare quarterly dividends for the foreseeable future.
Issuer Purchases of Equity Securities
Certain information regarding purchases made by or on behalf of us or any affiliated purchaser (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended) of our common stock during the three months ended June 30, 2006 is provided below:
Subsequent to June 30, 2006 and through September 12, 2006, we repurchased, in 7 separate open market transactions, an additional 478,300 shares of our common stock at a total cost of $16.7 million, representing an average price per share of $34.86. As of September 12, 2006, we had a remaining Board authorization to repurchase 2,473,000 shares.
Stockholder Rights Plan
We have a Stockholder Rights Plan, a description of which is set forth in Note 9 to the Consolidated Financial Statements included under Item 8 of this Annual Report and incorporated herein by reference. Such description contains all of the required information with respect thereto.
Item 6. Selected Financial Data
The following historical consolidated statement of operations and balance sheet data for the fiscal years ended June 30, 2006, 2005, 2004, 2003 and 2002 have been derived from our consolidated financial statements. The information set forth below should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements (including the notes thereto) included within this Annual Report.
See footnotes on following page.
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation
The following discussion of financial condition and results of operations is based upon, and should be read in conjunction with, our Consolidated Financial Statements (and notes thereto) included under Item 8 of this Annual Report.
Managements discussion and analysis of financial condition and results of operations and other sections of this Annual Report contain forward-looking statements relating to our future results. Such forward-looking statements are identified by use of forward-looking words such as anticipates, believes, plans, estimates, expects, and intends or words or phrases of similar expression. These forward-looking statements are subject to management decisions and various assumptions, risks and uncertainties, including, but not limited to: the effects of terrorist attacks or conflicts or wars involving the United States or its allies or trading partners; the effects of labor strikes; weather conditions that may affect sales; volatility in fuel, utility, transportation and security costs; changes in global or regional political or economic conditions, including changes in governmental and central bank policies; changes in business conditions in the furniture industry, including changes in consumer spending patterns and demand for home furnishings; effects of our brand awareness and marketing programs, including changes in demand for our existing and new products; our ability to locate new IDC sites and/or negotiate favorable lease terms for additional IDCs or for the expansion of existing IDCs; competitive factors, including changes in products or marketing efforts of others; pricing pressures; fluctuations in interest rates and the cost, availability and quality of raw materials; those matters discussed in Item 1A of this Annual Report and in our SEC filings; and our future decisions. Accordingly, actual circumstances and results could differ materially from those contemplated by the forward-looking statements.
Critical Accounting Policies
Our consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America which require, in some cases, that certain estimates and assumptions be made that affect the amounts and disclosures reported in those financial statements and the related accompanying notes. Estimates are based on currently known facts and circumstances, prior experience and other assumptions believed to be reasonable. We use our best judgment in valuing these estimates and may, as warranted, solicit external advice. Actual results could differ from these estimates, assumptions and judgments, and these differences could be material. The following critical accounting policies, some of which are impacted significantly by estimates, assumptions and judgments, affect our consolidated financial statements.
Inventories Inventories (finished goods, work in process and raw materials) are stated at the lower of cost, determined on a first-in, first-out basis, or market. Cost is determined based solely on those charges incurred in the acquisition and production of the related inventory (i.e. material, labor and manufacturing overhead costs). We estimate an inventory valuation allowance for excess quantities and obsolete items based on specific identification and historical write-downs, taking into account future demand and market conditions. If actual demand or market conditions in the future are less favorable than those estimated, additional inventory write-downs may be required.
Revenue Recognition Revenue is recognized when all of the following have occurred: persuasive evidence of a sales arrangement exists (e.g. a wholesale purchase order or retail sales invoice); the sales arrangement specifies a fixed or determinable sales price; product is shipped or services are provided to the customer; and collectibility is reasonably assured. As such, revenue recognition occurs upon the shipment of goods to independent retailers or, in the case of Ethan Allen-owned retail IDCs, upon delivery to the customer. Recorded sales provide for estimated returns and allowances. We permit our customers to return defective products and incorrect shipments, and terms we offer are standard for the industry.
Allowance for Doubtful Accounts We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. The allowance for doubtful accounts is based on a review of specifically identified accounts in addition to an overall aging analysis. Judgments are made with respect to the collectibility of accounts receivable based on historical experience and current economic trends. Actual losses could differ from those estimates.
Retail IDC Acquisitions We account for the acquisition of retail IDCs and related assets in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, which requires application of the purchase method for all business combinations initiated after June 30, 2001. Accounting for these transactions as purchase business combinations requires the allocation of purchase price paid to the assets acquired and liabilities assumed based on their fair values as of the date of the acquisition. The amount paid in excess of the fair value of net assets acquired is accounted for as goodwill.
Impairment of Long-Lived Assets and Goodwill We periodically evaluate whether events or circumstances have occurred that indicate that long-lived assets may not be recoverable or that the remaining useful life may warrant revision. When such events or circumstances are present, we assess the recoverability of long-lived assets by determining whether the carrying value will be recovered through the expected undiscounted future cash flows resulting from the use of the asset. In the event the sum of the expected undiscounted future cash flows is less than the carrying value of the asset, an impairment loss equal to the excess of the assets carrying value over its fair value is recorded. The long-term nature of these assets requires the estimation of cash inflows and outflows several years into the future and only takes into consideration technological advances known at the time of the impairment test.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill and other intangible assets are evaluated for impairment on an annual basis and between annual tests whenever events or circumstances indicate that the carrying value of the goodwill or other intangible asset may exceed its fair value. We conduct our required annual impairment test during the fourth quarter of each fiscal year and use a discounted cash flow model to estimate fair value. This model requires the use of long-term planning forecasts and assumptions regarding industry-specific economic conditions that are outside our control.
Business Insurance Reserves We have insurance programs in place to cover workers compensation and property/casualty claims. The insurance programs, which are funded through self-insured retention, are subject to various stop-loss limitations. We accrue estimated losses using actuarial models and assumptions based on historical loss experience. Although we believe that the insurance reserves are adequate, the reserve estimates are based on historical experience, which may not be indicative of current and future losses. In addition, the actuarial calculations used to estimate insurance reserves are based on numerous assumptions, some of which are subjective. We adjust insurance reserves, as needed, in the event that future loss experience differs from historical loss patterns.
Other Loss Reserves We have a number of other potential loss exposures incurred in the ordinary course of business such as environmental claims, product liability, litigation, tax liabilities, restructuring charges, and the recoverability of deferred income tax benefits. Establishing loss reserves for these matters requires the use of estimates and judgment with regard to maximum risk exposure and ultimate liability or realization. As a result, these estimates are often developed with our counsel, or other appropriate advisors, and are based on our current understanding of the underlying facts and circumstances. Because of uncertainties related to the ultimate outcome of these issues or the possibilities of changes in the underlying facts and circumstances, additional charges related to these issues could be required in the future.
Basis of Presentation
As of June 30, 2006, Ethan Allen Interiors Inc. has no material assets other than its ownership of the capital stock of Ethan Allen Global, Inc. and conducts all significant transactions through Ethan Allen Global, Inc.; therefore, substantially all of the financial information presented herein is that of Ethan Allen Global, Inc.
Results of Operations
Our revenues are comprised of (i) wholesale sales to independently-owned and Company-owned retail IDCs and (ii) retail sales of Company-owned IDCs. See Note 16 to our Consolidated Financial Statements for the year ended June 30, 2006 included under Item 8 of this Annual Report.
The components of consolidated revenues and operating income are as follows (in millions):
Fiscal 2006 Compared to Fiscal 2005
Consolidated revenue for the fiscal year ended June 30, 2006 totaled $1.1 billion, representing an increase of $117.4 million, or 12.4%, from fiscal 2005 consolidated revenue of $949.0 million. Net sales for the period largely reflect the delivery of product associated with booked orders and backlog existing as of the beginning of the period. During the year, sales benefited, primarily, from an increase in the incoming order rate as a result of (i) continued efforts to reposition the retail network, and (ii) new product introductions. In addition, sales were positively impacted, to some degree, by the continued implementation of our mission possible initiative, the objective of which is to reduce the lead time associated with product delivery to both our independent retailers and consumers.
To date, the repositioning of the retail network has involved three primary elements: the opening of new or relocated IDCs in larger and more prominent locations; development of a more focused advertising campaign to highlight our solutions-based approach and position Ethan Allen as an authority in style and design; and, during the last year, investment within the retail network to strengthen the existing management structure. Implementation of our project management initiative, which resulted in the promotion and/or hiring of approximately 200 project managers, has enabled us to increase the level of service, professionalism, interior design competence, efficiency, and effectiveness of retail IDC personnel. With project managers actively partnering with design consultants and their customers, we believe we have improved the customer service experience and facilitated, to some degree, better awareness of potential cross-selling opportunities.
Wholesale revenue for fiscal 2006 increased $72.9 million, or 11.0%, to $736.1 million from $663.2 million in the prior year. The year-over-year increase was attributable to an increase in the incoming order rate, coupled with increased throughput within our manufacturing operations, and improved service position within certain imported product lines, both of which resulted in shorter delivery cycle times and higher backlog turnover.
Retail revenue from Ethan Allen-owned IDCs for fiscal 2006 increased $104.8 million, or 17.9%, to $691.0 million from $586.2 million in the prior year. The increase in retail sales by Ethan Allen-owned IDCs was attributable to increases in comparable IDC delivered sales of $66.7 million, or 12.3%, and sales generated by newly opened (including relocated) or acquired IDCs of $56.2 million. These favorable variances were partially offset by a decrease resulting from sold and closed IDCs, which generated $18.1 million fewer sales in fiscal 2006 as compared to fiscal 2005. The number of Ethan Allen-owned IDCs increased to 139 as of June 30, 2006 as compared to 126 as of June 30, 2005. During that twelve month period, we acquired 12 IDCs from independent retailers, closed 1 IDC, and opened 8 IDCs (6 of which were relocations).
Comparable IDCs are those which have been operating for at least 15 months. Minimal net sales, derived from the delivery of customer ordered product, are generated during the first three months of operations for newly opened (or relocated) locations. IDCs acquired from independent retailers are included in comparable IDC sales in their 13th full month of Ethan Allen-owned operations.
Year-over-year, written business of Ethan Allen-owned IDCs increased 15.7% and comparable IDC written business increased 10.1%. Over that same period, wholesale orders increased 9.4%. The increase in both retail and wholesale written sales during the period was likely the result of (i) continued efforts to reposition the retail network, (ii) recent product introductions, and, to some degree, (iii) our use of national television as an advertising medium throughout the year.
Gross profit for fiscal 2006 increased $79.9 million, or 17.3%, to $541.0 million from $461.1 million in the prior fiscal year. This increase was primarily attributable to (i) an increase in total sales volume (including a higher proportionate share of retail sales to total sales (65% in the current period compared to 62% in the prior year period), and (ii) improved margins resulting from the continued off-shore sourcing of selected product lines and more efficient plant performance within our domestic manufacturing operations. These favorable variances were partially offset by increased costs associated with selected raw materials, namely foam, and utilities. Consolidated gross margin increased to 50.7% during the twelve months ended June 30, 2006 from 48.6% in the prior year comparable period as a result, primarily, of the factors identified previously.
Operating profit, the elements of which are discussed in greater detail below, was impacted by the following items during fiscal 2006:
In the first quarter of fiscal 2006, we announced a plan to convert one of our existing manufacturing facilities into a regional distribution center. The facility, involved in the production of wood case goods furniture, is located in Dublin, Virginia. In connection with this initiative, we permanently ceased production at the Dublin location and are currently in the process of consolidating the distribution operations of our existing Old Fort, North Carolina location into this new, larger facility. The decision impacted approximately 325 employees, of which approximately 75 have been (or will be) employed in new positions. A pre-tax restructuring and impairment charge of $4.2 million was recorded for costs associated with this plant conversion, of which $1.3 million was related to employee severance and benefits and other plant exit costs, and $2.9 million was related to fixed asset impairment charges, primarily for machinery and equipment, stemming from the decision to cease production activities. In addition, adjustments totaling $0.2 million were recorded during fiscal 2005 to reverse certain accruals previously established in connection with an earlier plant consolidation plan which were no longer required.
In addition, on July 1, 2005, we adopted the recognition and measurement provisions of SFAS No. 123(R), Share-Based Payment, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supercedes Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations. SFAS No. 123(R) requires compensation costs related to share-based payment transactions, including employee stock options, to be recognized in our financial statements. In adopting SFAS No. 123(R), we applied the modified prospective approach to transition which requires that the provisions of SFAS No. 123(R) be applied to new awards and to awards modified, repurchased, or cancelled after the required effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that are outstanding as of the required effective date shall be recognized as the requisite service is rendered on or after the required effective date. The compensation cost for that portion of awards shall be based on the grant-date fair value of those awards as calculated for either recognition or pro-forma disclosures under SFAS No. 123.
As a result of the adoption of SFAS No. 123(R), operating expenses for the twelve month period ended June 30, 2006 include share-based compensation expense totaling $1.9 million. For the prior year comparable period, during which time we applied the APB No. 25 intrinsic value method of measuring compensation cost, the cost associated with share-based compensation arrangements totaled $0.3 million. As of June 30, 2006, there was $1.4 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 2.5 years.
Including the restructuring and impairment and share-based compensation charges referred to above, operating expenses increased $66.2 million, or 19.9%, to $398.3 million, or 37.4% of net sales, in the current year from $332.1 million, or 35.0% of net sales, in the prior year. This increase was primarily attributable to increased costs associated with our continued efforts to reposition the retail network which has resulted in higher costs associated with managerial salaries and benefits, commissions, occupancy, and delivery and warehousing. In addition, current year operating expenses were unfavorably impacted by (i) increased distribution costs attributable to higher fuel and freight charges, some of which stems from the improved sales volume noted during the period, (ii) an increase in advertising costs, largely as a result of our decision to utilize national television as an advertising medium throughout the year, (iii) the aforementioned restructuring and impairment charge, and (iv) an increase in compensation and benefit related expenses.
Including the restructuring and impairment and share-based compensation charges referred to above, consolidated operating income for the year ended June 30, 2006 totaled $142.7 million, or 13.4% of net sales, as compared to $129.0 million, or 13.6% of net sales, in the prior year. This represents an increase of $13.7 million, or 10.6%, and was attributable to the overall increase in gross profit referred to previously, partially offset by higher operating expenses noted during the period.
Including the restructuring and impairment and share-based compensation charges referred to above, wholesale operating income for the year ended June 30, 2006 was $125.2 million, as compared to $115.9 million for the prior year. The wholesale operating margin in fiscal 2006 and fiscal 2005 amounted to 17.0% and 17.5%, respectively. The $9.3 million, or 8.0%, increase in wholesale operating income was primarily attributable to (i) the increase in wholesale sales volume, and (ii) the continued off-shore sourcing of selected product lines and improved margins attributable to more efficient plant performance within our domestic manufacturing operations, partially offset by higher costs associated with selected raw materials, namely foam, and utilities. These increases were further offset by (i) increased distribution costs attributable to higher fuel and freight charges, (ii) an increase in advertising costs as a result of our decision to utilize national television as an advertising medium throughout the year, (iii) the aforementioned restructuring and impairment charge, (iv) an increase in compensation and benefit related expenses, and (v) losses incurred in connection with the disposition of certain plant machinery and equipment.
Retail operating income increased $6.9 million, or 54.4%, to $19.7 million for fiscal 2006, as compared to $12.8 million in the prior year. The retail operating margin in fiscal 2006 and fiscal 2005 amounted to 2.9% and 2.2%,
respectively. The increase in retail operating income generated by Ethan Allen-owned IDCs is primarily attributable to higher sales volume generated by comparable, and newly-opened (including relocations) or acquired IDCs, partially offset by higher operating expenses as a result of our continued efforts to reposition the retail network and a decline in operating income associated with IDCs sold or closed during the year.
Interest and other miscellaneous income (net) totaled $4.9 million in fiscal 2006 as compared to $1.2 million in fiscal 2005. The $3.7 million increase was due, primarily, to increased investment income resulting from higher cash and short-term investment balances maintained during the current year, partially offset by higher prior year gains recorded in connection with the sale of real estate.
Interest and other related financing costs for fiscal 2006 increased $8.7 million to $9.5 million from $0.8 million in the prior year. The increase was due, primarily, to interest expense incurred in connection with our issuance of senior unsecured debt in September 2005.
Income tax expense totaled $52.4 million in fiscal 2006 as compared to $50.1 million in fiscal 2005. Our effective tax rate for the current year was 38.0%, down from 38.7% in the prior year. The lower effective tax rate was a result, primarily, of the benefits derived from the manufacturers deduction provided for under The Jobs Creation Act of 2004 and certain state-tax planning initiatives. Partially offsetting these items were the adverse effects of recently-enacted changes within certain state tax legislation, and increased state income tax liability arising in connection with the operation of a greater number of Company-owned IDCs.
For fiscal 2006, we recorded net income of $85.7 million as compared to $79.3 million in fiscal 2005. Net income per diluted share totaled $2.51 in the current year and $2.19 in the prior year.
Fiscal 2005 Compared to Fiscal 2004
Consolidated revenue for fiscal 2005 totaled $949.0 million, representing a decrease of $6.1 million, or 0.6%, from fiscal 2004 consolidated revenue of $955.1 million. Net sales for the period reflect the delivery of product associated with a slight decline in total booked orders, and the resultant lower level of backlog noted throughout most of the year. The modest decrease in net sales for the year was due, primarily, to (i) inconsistent consumer spending habits noted throughout much of the last twelve months likely attributable to ongoing economic uncertainty caused by the threat of further interest rate increases, rising fuel prices and a decline in the stock markets, and (ii) our transition to everyday pricing from periodic sale events conducted in the prior year. These factors were partially offset by the continued re-positioning of our retail IDCs to larger and more prominent locations and the impact of recent product introductions. Overall, sales volume for the period was impacted by increased industry competition and the continued use of highly-promotional pricing strategies by our competitors.
Wholesale revenue for fiscal 2005 decreased $10.6 million, or 1.6%, to $663.2 million from $673.8 million in the prior year. The year-over-year decrease was attributable to a decline in the incoming order rate noted during the period, particularly within our case goods operations, partially offset by increased throughput within our upholstery operations, and improved service position, resulting in shorter delivery cycle times, within certain imported product lines.
Retail revenue from Ethan Allen-owned IDCs for fiscal 2005 increased $10.0 million, or 1.7%, to $586.2 million from $576.2 million in the prior year. This increase in retail delivered sales by Ethan Allen-owned IDCs was attributable to an increase in sales generated by newly-opened (including relocations) or acquired IDCs of $25.7 million, partially offset by decreases in comparable IDC delivered sales of $1.2 million, or 0.2%, and closed IDCs, which generated $14.5 million fewer sales in fiscal 2005 as compared to fiscal 2004. The number of Ethan Allen-owned IDCs decreased to 126 as of June 30, 2005 as compared to 127 as of June 30, 2004. During that twelve
month period, we acquired 6 IDCs from, and sold 4 IDCs to, independent retailers, closed 5 IDCs and opened 7 IDCs (5 of which were relocations).
Total booked orders, which include wholesale orders and written business of Ethan Allen-owned retail IDCs, decreased 1.4% from the prior year. Year-over-year, wholesale orders decreased 3.0% while Ethan Allen-owned IDC orders increased 2.9% and comparable IDC written business increased 1.0%. The modest increase in retail written sales was likely attributable to the continued re-positioning of our retail IDCs to larger and more prominent locations. During the year, we increased distribution of the Furnishing Solutions by Ethan Allen direct mail magazine, distributing approximately 57 million copies which represented a 45% increase over historical annual levels. These positive factors were likely offset, to some degree, by the current year transition to everyday pricing from periodic sale events conducted in the prior year.
Gross profit for fiscal 2005 totaled $461.0 million and was effectively unchanged from prior year. Consolidated gross profit was favorably impacted by a higher proportionate share of retail sales to total sales (62% in fiscal 2005 compared to 60% in fiscal 2004), an overall increase in retail sales volume as a result of the continued re-positioning of our IDC network, and a reduction in costs associated with excess capacity at our manufacturing facilities. These favorable variances were offset by gross profit declines resulting, primarily, from (i) an overall decrease in wholesale shipments, (ii) ordinary inefficiencies within our case goods operations associated with the production of first cuts for new collections, and (iii) price increases within selected raw material categories, namely lumber, foam, plywood and steel. Consolidated gross margin increased to 48.6% for the year ended June 30, 2005 from 48.3% in the prior year as a result, primarily, of the factors identified previously.
Operating expenses decreased $2.5 million, or 0.7%, to $332.1 million, or 35.0% of net sales, in fiscal 2005 from $334.6 million, or 35.0% of net sales, in the prior year, which included restructuring and impairment charges, net of $12.5 million. This decrease is primarily attributable to (i) the aforementioned restructuring and impairment charge recorded in the fourth quarter of the prior year, (ii) cost savings attributable to the closure of selected plant locations, and (iii) a decrease in advertising costs within the wholesale segment stemming from our decision to increase distribution of our direct mail magazine in lieu of more costly national television advertising. These favorable variances were partially offset by costs associated with the continued re-positioning of our retail IDCs to larger and more prominent locations, and increased distribution expenses attributable to higher fuel and freight charges. The initiative to re-position our retail IDC network has resulted in higher costs associated with managerial salaries and benefits, occupancy, credit card fees, advertising, and delivery and warehousing.
Consolidated operating income was $129.0 million, or 13.6% of net sales, for the year ended June 30, 2005, as compared to $126.4 million, or 13.2% of net sales, for the year ended June 30, 2004, which included restructuring and impairment charges, net of $12.5 million. This represents an increase of $2.6 million, or 2.0%, which is primarily attributable to lower operating expenses as referred to previously.
Wholesale operating income for the year ended June 30, 2005 was $115.9 million, or 17.5% of wholesale sales, as compared to $108.0 million, or 16.0% of wholesale sales, for the year ended June 30, 2004, which included restructuring and impairment charges, net of $12.5 million. The increase of $7.9 million, or 7.3%, is primarily attributable to (i) the aforementioned restructuring and impairment charge recorded in the fourth quarter of the prior year, (ii) a decrease in advertising costs, particularly as it relates to national television advertising, (iii) a reduction in costs associated with excess capacity at our manufacturing facilities, and (iv) cost savings attributable to the closure of selected plant locations in recent periods. These decreases were partially offset by (i) an overall decline in wholesale sales volume, (ii) price increases within selected raw material categories, (iii) an increase in selling expenses primarily related to the increased distribution of our direct mail magazine, and (iv) an increase in distribution expenses attributable to higher fuel and freight charges.
Retail operating income increased $1.1 million, or 9.4%, to $12.8 million, or 2.2% of retail sales, for fiscal 2005, as compared to $11.7 million, or 2.0% of retail sales, in fiscal 2004. The increase in retail operating income generated
by Ethan Allen-owned IDCs is primarily attributable to higher sales volume generated from newly-opened (including relocations) or acquired IDCs, and the gain recorded upon the sale of selected IDCs. These increases were partially offset by higher operating expenses related to the continued re-positioning of our retail IDC network, and, to a lesser extent, the sell-off of floor inventory necessary to make room for new product introductions.
Interest and other miscellaneous income (net) totaled $1.2 million in fiscal 2005 as compared to $3.3 million in fiscal 2004. The decrease was due, primarily, to a decrease in interest income associated with the lower cash balances maintained during the period, and the favorable settlement of an outstanding legal matter during the prior year period.
Income tax expense totaled $50.1 million for fiscal 2005 as compared to $49.6 million for fiscal 2004. Our effective tax rate was 38.7% in fiscal 2005, up from 38.4% in fiscal 2004. The higher effective tax rate is a result of changes enacted within certain state tax legislation, and increased state income tax liability arising in connection with the operation of a greater number of Company-owned IDCs, some of which are located in new jurisdictions.
For fiscal 2005, we recorded net income of $79.3 million as compared to $79.5 million in fiscal 2004. Net income per diluted share totaled $2.19 in fiscal 2005 and $2.08 in the prior year.
Liquidity and Capital Resources
As of June 30, 2006, we maintained cash and cash equivalents totaling $173.8 million. Our principal sources of liquidity include cash and cash equivalents, cash flow from operations, and borrowing capacity under a $200.0 million revolving credit facility.
The credit facility includes an accordion feature which provides for an additional $100.0 million of liquidity, if needed, as well as sub-facilities for trade and standby letters of credit of $100.0 million and swingline loans of $5.0 million. The credit facility contains various covenants which may limit our ability to: incur debt; engage in mergers and consolidations; make restricted payments; sell certain assets; make investments; and issue stock. We are also required to meet certain financial covenants including a fixed charge coverage ratio, which shall not be less than 3.00 to 1 for any period of four consecutive fiscal quarters ended on or after June 30, 2005, and a leverage ratio, which shall not be greater than 3.00 to 1 at any time. As of June 30, 2006, we had satisfactorily complied with these covenants.
In addition, on September 27, 2005, we completed a private offering of $200.0 million in ten-year senior unsecured notes due 2015 (the Senior Notes). The Senior Notes were offered by Ethan Allen Global, Inc. (Global), a wholly-owned subsidiary of the Company, and have an annual coupon rate of 5.375%. We intend to utilize the net proceeds of $198.4 million to expand our retail network, invest in our manufacturing and logistics operations, and for other general corporate purposes.
In connection with the issuance of the Senior Notes, Global, in July and August 2005, entered into 6 separate forward contracts to hedge the risk-free interest rate associated with $108.0 million of the related debt in order to minimize the negative impact of interest rate fluctuations on earnings, cash flows and equity. The forward contracts were entered into with a major banking institution thereby mitigating the risk of credit loss. Upon issuance of the Senior Notes and settlement of the related forward contracts, losses totaling $0.9 million were incurred representing the change in the fair value of the forward contracts since their respective trade dates. In accordance with SFAS No. 133, Accounting for Certain Derivative Instruments and Certain Hedging Activities, as amended, it was determined that a portion of the related losses was the result of hedge ineffectiveness and, as such, $0.1 million of the losses was included, within interest and other related financing costs, in the Consolidated Statement of Operations for the three month period ended September 30, 2005. The balance of the losses has been included (on a net-of-tax basis) in the Consolidated Balance Sheets within
accumulated other comprehensive income and is being amortized to interest expense over the life of the Senior Notes. The remaining unamortized balance of the forward contract losses totaled $0.7 million as of June 30, 2006.
A summary of net cash provided by (used in) operating, investing, and financing activities for each of the last three fiscal years is provided below (in millions):
As of June 30, 2006, our outstanding debt and capital lease obligations totaled $202.8 million, the current and long-term portions of which amounted to $0.1 million and $202.7 million, respectively. The aggregate scheduled maturities of long-term debt, including capital lease obligations, for each of the next five fiscal years are: less than $0.1 million in each of fiscal 2007, 2008, 2009, and 2010; and $3.9 million in fiscal 2011. The balance of our long-term debt ($198.7 million) matures in fiscal years 2012 and thereafter.
We had no revolving loans outstanding under the credit facility as of June 30, 2006, and stand-by letters of credit outstanding under the facility at that date totaled $16.2 million. Remaining available borrowing capacity under the facility was $183.8 million at June 30, 2006.
The following table summarizes, as of June 30, 2006, the timing of cash payments related to our outstanding contractual obligations (in thousands):
Further discussion of our contractual obligations associated with outstanding debt and lease arrangements can be found in Notes 7 and 8, respectively, to the Consolidated Financial Statements included under Item 8 of this Annual Report.
We believe that our cash flow from operations, together with our other available sources of liquidity, will be adequate to make all required payments of principal and interest on our debt, to permit anticipated capital expenditures, and to fund working capital and other cash requirements. As of June 30, 2006, we had working capital of $278.0 million and a current ratio of 2.91 to 1.
In addition to using available cash to fund changes in working capital, necessary capital expenditures, acquisition activity, the repayment of debt, and the payment of dividends, we have been authorized by our Board of Directors to repurchase our common stock, from time to time, either directly or through agents, in the open market at prices and on terms satisfactory to us. All of our common stock repurchases and retirements are recorded as treasury stock and result in a reduction of shareholders equity.
During fiscal years 2006, 2005 and 2004, we repurchased and/or retired the following shares of our common stock:
For each of the fiscal years presented above, we funded our purchases of treasury stock with existing cash on hand and cash generated through current period operations. During the last three fiscal years, the Board of Directors increased the then remaining share repurchase authorization as follows: to 2.5 million shares on April 27, 2004; to 2.0 million shares on November 16, 2004; to 2.0 million shares on April 26, 2005; and to 2.5 million shares on November 15, 2005. As of June 30, 2006 we had a remaining Board authorization to repurchase 1.6 million shares.
Subsequent to June 30, 2006 and through September 12, 2006, we repurchased, in 7 separate open market transactions, an additional 478,300 shares of our common stock at a total cost of $16.7 million, representing an average price per share of $34.86. On July 25, 2006, the Board of Directors increased the then remaining share repurchase authorization to 2.5 million shares. As of September 12, 2006, we had a remaining Board authorization to repurchase 2,473,000 shares.
Off-Balance Sheet Arrangements and Other Commitments, Contingencies and Contractual Obligations
Except as indicated below, we do not utilize or employ any off-balance sheet arrangements, including special-purpose entities, in operating our business. As such, we do not maintain any (i) retained or contingent interests, (ii) derivative instruments (other than as specified below), or (iii) variable interests which could serve as a source of potential risk to our future liquidity, capital resources and results of operations.
In connection with the issuance of the Senior Notes, Global, in July and August 2005, entered into 6 separate forward contracts to hedge the risk-free interest rate associated with $108.0 million of the related debt in order to minimize the negative impact of interest rate fluctuations on earnings, cash flows and equity. The forward contracts were entered into with a major banking institution thereby mitigating the risk of credit loss. Upon issuance of the Senior Notes in September 2005, the related forward contracts were settled. At the present time we have no current plans to engage in further hedging activities.
We may, from time to time in the ordinary course of business, provide guarantees on behalf of selected affiliated entities or become contractually obligated to perform in accordance with the terms and conditions of certain business agreements. The nature and extent of these guarantees and obligations may vary based on our underlying relationship with the benefiting party and the business purpose for which the guarantee or obligation is being provided. Details of those arrangements for which we act as guarantor or obligor are provided below.
based on the value of the underlying inventory) and, as such, is not an estimate of future cash flows. No specific recourse or collateral provisions exist that would enable recovery of any portion of amounts paid under this obligation, except to the extent that we maintain the right to take title to the repurchased inventory. We anticipate that the repurchased inventory could subsequently be sold through our retail IDC network.
As of June 30, 2006, the amount outstanding under the Credit Facility totaled approximately $1.0 million, of which $0.9 million was outstanding under the revolving credit line. Based on the underlying creditworthiness of the respective retailer, we believe this obligation will expire without requiring funding by us. However, in accordance with the provisions of FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, a liability has been established to reflect our non-contingent obligation under this arrangement as a result of modifications made to the Credit Facility subsequent to January 1, 2003. As of June 30, 2006, the carrying amount of such liability is less than $50,000.
Impact of Inflation
We do not believe that inflation has had a material impact on our profitability during the last three fiscal years. In the past, we have generally been able to increase prices or seek lower cost alternatives in order to offset increases in operating costs and effectively manage our working capital.
At June 30, 2006, we had, for federal income tax purposes, approximately $2.2 million of net operating loss carryforwards (NOLs) which expire between 2022 and 2025. Our utilization of $1.9 million of these NOLs is limited, pursuant to Section 381(c) of the Internal Revenue Code (IRC), based upon the separate earnings and/or eventual liquidation of the wholly-owned subsidiary to which the NOLs relate. The remaining $0.3 million of NOLs is subject to an annual limitation under Section 382 of the IRC. Based on our historical and anticipated future pre-tax earnings, we believe that it is more likely than not that these NOLs will be utilized.
While we cannot reasonably predict whether the encouraging signs noted during fiscal 2006 with respect to the incoming order rate will prove to be sustainable, we believe that we are well-positioned for the next phase of economic growth based upon our existing business model which includes: (i) an established brand; (ii) a comprehensive complement of home decorating solutions; and (iii) a vertically-integrated operating structure.
As macro-economic factors change, however, it is also possible that our costs associated with production (including raw materials and labor), distribution (including freight and fuel charges), and retail operations (including compensation and benefits, delivery and warehousing, occupancy, and advertising expenses) may increase. We cannot reasonably predict when, or to what extent, such events may occur or what effect, if any, such events may have on our consolidated financial condition or results of operations.
The home furnishings industry remains extremely competitive with respect to both the sourcing of products and the retail sale of those products. Domestic manufacturers continue to face pricing pressures as a result of the manufacturing capabilities developed during recent years in other countries, specifically within Asia. In response to these pressures, a large number of U.S. furniture manufacturers and retailers, including us, have increased their overseas sourcing activities in an attempt to maintain a competitive advantage and retain market share. At the present time, we domestically manufacture and/or assemble approximately 60-65% of our products. We continue to believe that a balanced approach to product sourcing, which includes the domestic manufacture of certain product offerings coupled with the import of other selected products, provides the greatest degree of flexibility and is the most effective approach to ensuring that acceptable levels of quality, service and value are attained.
In addition, we believe that our retail strategy, which involves (i) a continued focus on providing a wide array of product solutions and superior customer service, (ii) the opening of new or relocated IDCs in larger and more prominent locations, while encouraging independent retailers to do the same, and (iii) the development of a more professional management structure within our retail network, provides an opportunity to further grow our business.
Further discussion of the home furnishings industry has been included under Item 1 of this Annual Report.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 provides a comprehensive model for the recognition, measurement, presentation, and disclosure in a companys financial statements of uncertain tax positions taken, or expected to be taken, on a tax return. If an income tax position exceeds a more likely than not (i.e. greater than 50%) probability of success upon tax audit, the company is to recognize an income tax benefit in its financial statements. Additionally, companies are required to accrue interest and related penalties, if applicable, on all tax exposures consistent with the respective jurisdictional tax laws. This interpretation is effective for fiscal years beginning after December 15, 2006 (July 1, 2007 for the Company). As such, we are currently in the process of evaluating the impact, if any, of this authoritative guidance on our consolidated financial statements.
In June 2006, the Emerging Issues Task Force (EITF) of the FASB reached a consensus on EITF Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (i.e., Gross versus Net Presentation), which relates to sales, use, value added and selected excise taxes assessed by a governmental authority on specific revenue-producing transactions between a seller and its customers. EITF 06-3 states that the presentation of such taxes, on either a gross or net basis, is an accounting policy decision that should be disclosed pursuant to Accounting Principles Board Opinion No. 22, Disclosure of Accounting Policies, if those amounts are significant. EITF 06-3 is to be applied to financial reports for interim and annual reporting periods beginning after December 15, 2006 (January 1, 2007 for the Company). The adoption of EITF 06-3 is not expected to have a material effect on our consolidated financial statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risks relating to fluctuations in interest rates and foreign currency exchange rates.
Interest rate risk exists primarily through our borrowing activities. Our policy has been to utilize United States dollar denominated borrowings to fund our working capital and investment needs. Short-term debt, if required, is used to meet working capital requirements and long-term debt is generally used to finance long-term investments. There is inherent rollover risk for borrowings as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable because of the variability of future interest rates and our future financing requirements.
For floating-rate obligations, interest rate changes do not affect the fair value of the underlying financial instrument but do impact future earnings and cash flows, assuming other factors are held constant. Conversely, for fixed-rate obligations, interest rate changes affect the fair value of the underlying financial instrument but do not impact earnings or cash flows. At June 30, 2006, we had no floating-rate debt obligations outstanding. As of that same date, our fixed-rate debt obligations consist, primarily, of the Senior Notes issued on September 27, 2005. The estimated fair value of the Senior Notes as of June 30, 2006, which is based on interest rate changes subsequent to the date on which the debt was issued, and which has been determined using quoted market prices, was $183.4 million as compared to a carrying value of $198.5 million.
Foreign currency exchange risk is primarily limited to our operation of 5 Ethan Allen-owned retail IDCs located in Canada as substantially all purchases of imported parts and finished goods are denominated in United States dollars. As such, gains or losses resulting from market changes in the value of foreign currencies have not had, nor are they expected to have, a material effect on our consolidated results of operations.
Historically, we have not entered into financial instrument, including derivative, transactions for trading or other speculative purposes or to manage interest rate or currency exposure. However, in connection with the issuance of the Senior Notes, Global, in July and August 2005, entered into 6 separate forward contracts to hedge the risk-free interest rate associated with $108.0 million of the related debt in order to minimize the negative impact of interest rate fluctuations on earnings, cash flows and equity. The forward contracts were entered into with a major banking institution thereby mitigating the risk of credit loss. Upon issuance of the Senior Notes in September 2005, the related forward contracts were settled. At the present time, we have no current plans to engage in further hedging activities.
Item 8. Financial Statements and Supplementary Data
Our Consolidated Financial Statements and Supplementary Data are listed under Item 15 of this Annual Report.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors
We have audited the accompanying consolidated balance sheets of Ethan Allen Interiors Inc. and Subsidiaries (the Company) as of June 30, 2006 and 2005, and the related consolidated statements of operations, shareholders equity, and cash flows for each of the years in the three-year period ended June 30, 2006. We also have audited managements assessment, included in the accompanying Managements Report on Internal Control Over Financial Reporting, that Ethan Allen Interiors Inc. and Subsidiaries maintained effective internal control over financial reporting as of June 30, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Companys management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these consolidated financial statements, an opinion on managements assessment, and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ethan Allen Interiors Inc. and Subsidiaries as of June 30, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended June 30, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, managements assessment that Ethan Allen Interiors Inc. and Subsidiaries maintained effective internal control over financial reporting as of June 30, 2006, is fairly stated, in all material respects, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, Ethan Allen Interiors Inc. and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of June 30, 2006, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
As discussed in Notes 1 and 11 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, as of July 1, 2005.
ETHAN ALLEN INTERIORS
INC. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
ETHAN ALLEN INTERIORS
INC. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
ETHAN ALLEN INTERIORS
INC. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
ETHAN ALLEN INTERIORS
INC. AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
ETHAN ALLEN INTERIORS
INC. AND SUBSIDIARIES
The above amounts will be offset in the aggregate by minimum future rentals from subleases of $14.0 million.
required effective date. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that are outstanding as of the required effective date shall be recognized as the requisite service is rendered on or after the required effective date. The compensation cost for that portion of awards shall be based on the grant-date fair value of those awards as calculated for either recognition or pro-forma disclosures under SFAS No. 123.
As a result of the adoption of SFAS No. 123(R), our results for the twelve month period ended June 30, 2006 included share-based compensation expense totaling $1.9 million. Such amount has been included in the Consolidated Statement of Operations within selling, general and administrative expenses. During that same period, we recognized a related tax benefit associated with our share-based compensation arrangements totaling $0.7 million.
Consistent with our practice prior to the adoption of SFAS No. 123(R), we estimate, as of the date of grant, the fair value of stock options awarded using the Black-Scholes option-pricing model. Use of a valuation model requires management to make certain assumptions with respect to selected model inputs, including anticipated changes in the underlying stock price (i.e. expected volatility) and option exercise activity (i.e. expected life). Expected volatility is based on the historical volatility of our stock and other contributing factors. The expected life of options granted, which represents the period of time that the options are expected to be outstanding, is based, primarily, on historical data.
Subsequent to the adoption of SFAS No. 123(R), we continue to utilize the same forms of share-based awards that we had previously. We had 6,320,139 shares of common stock reserved for issuance pursuant to the following share-based compensation plans:
1992 Stock Option Plan
M. Farooq Kathwari, our President and Chief Executive Officer, entered into an employment agreement with the Company dated August 1, 2002 (the 2002 Employment Agreement). This agreement was effective as of July 1, 2002 and served to supercede all terms and conditions set forth in his previous employment agreement dated July 1, 1997, which expired on June 30, 2002 (the 1997 Employment Agreement). Pursuant to the terms of the 2002 Employment Agreement, Mr. Kathwari was awarded, on August 1, 2002, August 1, 2003, and August 1, 2004, options to purchase 600,000, 400,000 and 200,000 shares, respectively, of our common stock. These options were issued at exercise prices of $31.02, $35.53, and $37.15 per share, respectively, (the price of a share of our common stock on the New York Stock Exchange as of such dates). The 2002 grant vested ratably over a 3-year period, while the fiscal 2003 grant vested ratably over a 2-year period, and the 2004 grant vested ratably over a 1-year period. As of June 30, 2006, all of Mr. Kathwaris options are fully vested.