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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
LIQUIDITY AND CAPITAL RESOURCES At June 30, 2006, our outstanding borrowings of $521.5 million included: (i) $230.0 million of 6% Senior Notes due January 2012 consisting of $250.0 million principal, unamortized debt discount of $0.6 million and a $19.4 million adjustment to reflect the fair value of an outstanding interest rate swap; (ii) $197.4 million of 5.75% Senior Notes due October 2033 consisting of $200.0 million principal and unamortized debt discount of $2.6 million; (iii) a 1.8 million Euro note (approximately $1.9 million at the exchange rate at June 30, 2006) payable semi-annually through February 2008 at a variable interest rate; (iv) $7.1 million of capital lease obligations; (v) a 3.0 billion yen short-term borrowing under a revolving credit facility (approximately $26.2 million at the exchange rate at June 30, 2006); (vi) $38.0 million of outstanding loan participation notes due July 2006 at an initial interest rate of 5.41%; and (vii) $20.9 million of other short-term borrowings. We have a $750.0 million commercial paper program under which we may issue commercial paper in the United States. Our commercial paper is currently rated A-1 by Standard & Poor's and P-1 by Moody's. Our long-term credit ratings are A+ with a stable outlook by Standard & Poor's and A1 with a stable outlook by Moody's. At June 30, 2006, we had no commercial paper outstanding. We also have an effective shelf registration statement covering the potential issuance of up to an additional $300.0 million in debt securities and $150.2 million in additional uncommitted credit facilities, of which $20.9 million was used as of June 30, 2006. We have an unused $600.0 million senior revolving credit facility that expires on May 27, 2010. The facility may be used for general corporate purposes, including financing working capital, and also as credit support for our commercial paper program. Up to the equivalent of $250.0 million of the facility is available for multi-currency loans. The interest rate on borrowings under the credit facility is based on LIBOR or on the higher of prime, which is the rate of interest publicly announced by the administrative agent, or the Federal funds rate plus 1/2%. The credit facility has an annual fee of $0.4 million, payable quarterly, based on our current credit ratings. As of June 30, 2006, we were in compliance with all related financial and other restrictive covenants, including limitations on indebtedness and liens. In May 2006, we entered into a fixed rate promissory note agreement with a financial institution for the primary purpose of funding cash dividend repatriations from certain of our international affiliates to the United States as permitted by the AJCA. Under the agreement, we may borrow up to $150.0 million in the form of loan participation notes which were issued by one of our subsidiaries in Europe. The interest rate on borrowings under this agreement will be an all-in fixed rate determined by the lender and agreed to by us at the date of each borrowing. At June 30, 2006, $38.0 million was outstanding under this agreement and the notes are being refinanced on a periodic basis as they mature at the then prevailing market interest rates. Debt issuance costs incurred related to this agreement were de minimis. In March 2006, we entered into a 3.0 billion yen revolving credit facility that expires on March 24, 2009. The interest rate on borrowings under the credit facility is based on TIBOR (Tokyo Interbank Offered Rate) and a 10 basis point facility fee is incurred on the undrawn balance. We borrowed 3.0 billion yen under the new facility on March 28, 2006 to repay the previously outstanding 3.0 billion yen term loan that was to mature on that date. The outstanding balance at June 30, 2006 ($26.2 million at the exchange rate at June 30, 2006) is classified as short-term debt on our consolidated balance sheet. In October 2005, we redeemed the remaining $68.4 million of the 2015 Preferred Stock that was outstanding at June 30, 2005 and paid the accrued dividends thereon. Our business is seasonal in nature and, accordingly, our working capital needs vary. From time to time, we may enter into investing and financing transactions that require additional funding. To the extent that these needs exceed cash from operations, we could, subject to market conditions, issue commercial paper or loan participation notes, issue long-term debt securities or borrow under the revolving credit facility or other credit facilities. Total debt as a percent of total capitalization was 24% at June 30, 2006 and 30% at June 30, 2005. The effects of inflation have not been significant to our overall operating results in recent years. Generally, we have been able to introduce new products at higher selling prices or increase selling prices sufficiently to offset cost increases, which have been moderate. We believe that cash on hand, cash generated from operations, available credit lines and access to credit markets will be adequate to support currently planned business operations and capital expenditures on both a near-term and long-term basis.
Cash Flows Net cash provided by operating activities was $478.1 million in fiscal 2005 and $673.0 million in fiscal 2004. The net decrease reflected changes in certain working capital accounts, partially offset by decreases in net deferred taxes and an increase in net earnings from continuing operations. The change in other accrued liabilities primarily reflected the payment of significant deferred compensation and supplemental payments made to retired executives in fiscal 2005. Accounts receivable increased as a result of sales growth in fiscal 2005, reflecting growth in international markets and customers which generally carry longer payment terms. The timing of payments from certain domestic customers as well as shipments that occurred later in the period also contributed to increased accounts receivable. The increase in inventory was primarily due to actual and anticipated sales levels, the building of safety stock in our new distribution center in Europe, and, to a lesser extent, the inclusion of new points of distribution. The shift in cash activities related to accounts payable reflected the timing of disbursements year-over-year as well as the initiation of a vendor-managed inventory program. Net deferred taxes decreased primarily due to the then-anticipated repatriation of foreign earnings in fiscal 2006 as a result of the AJCA and the realization of the tax benefits related to payments made to retired executives. Net cash used for investing activities was $303.2 million in fiscal 2006 compared with $237.0 million in fiscal 2005 and $213.7 million in fiscal 2004. The increase in cash flows used for investing activities during fiscal 2006 primarily reflected the cash payment related to the Jo Malone Limited earn-out provision and, to a lesser extent, Aveda distributor acquisitions. Capital expenditures also increased in fiscal 2006 primarily reflecting our continuing company-wide initiative to upgrade our information systems, which was initiated in fiscal 2005. Fiscal 2005 capital expenditures reflected those costs related to our information systems as well as the investment in leasehold improvements in our corporate offices. Capital expenditures in fiscal 2004 primarily reflected the continued upgrade of manufacturing equipment, dies and molds, new store openings, store improvements, counter construction and information technology enhancements. In fiscal 2007, we expect to purchase the remaining equity interest in Bumble and Bumble Products, LLC and Bumble and Bumble, LLC. Cash used for financing activities was $594.6 million, $300.4 million and $216.0 million in fiscal 2006, 2005 and 2004, respectively. In addition to common stock repurchases and dividend payments, cash flows used for financing activities reflected the repayment of short-term commercial paper that was outstanding at June 30, 2005 and the October 2005 redemption of the remaining 2015 Preferred Stock. These outflows were partially offset by short-term borrowings under our loan participation note program. The 3.0 billion yen term loan outstanding at the end of fiscal 2005 was refinanced by borrowings under the new 3.0 billion yen revolving credit facility that we entered into in March 2006. The net cash used for financing activities in fiscal 2005 primarily reflected common stock repurchases and dividend payments, partially offset by the issuance of short-term commercial paper to fund working capital needs and the receipt of proceeds from employee stock option transactions. The net cash used for financing activities in fiscal 2004 primarily related to the redemption of $291.6 million aggregate principal amount of the 2015 Preferred Stock, common stock repurchases and dividend payments partially offset by proceeds from the issuance of the 5.75% Senior Notes and from employee stock option transactions.
Dividends
Pension Plan Funding and Expense Several factors influence our annual funding requirements. For the U.S. Qualified Plan, our funding policy consists of annual contributions at a rate that provides for future plan benefits and maintains appropriate funded percentages. Such contribution is not less than the minimum required by the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and subsequent pension legislation, and is not more than the maximum amount deductible for income tax purposes. For each international plan, our funding policies are determined by local laws and regulations. In addition, amounts necessary to fund future obligations under these plans could vary depending on estimated assumptions (as detailed in "Critical Accounting Polices and Estimates"). The effect of our pension plan funding on future operating results will depend on economic conditions, employee demographics, mortality rates, the number of participants electing to take lump-sum distributions, investment performance and funding decisions. For fiscal 2006 and 2005, there was no minimum contribution to the U.S. Qualified Plan required by ERISA. However, while we did not make any cash contributions pursuant to the plan during fiscal 2006, we made cash contributions of $2.0 million during fiscal 2005 at management's discretion. During fiscal 2007, we do not expect to make any cash contributions to the U.S. Qualified Plan. For fiscal 2006 and 2005, we made benefit payments under our non-qualified domestic noncontributory pension plan of $7.4 million and $5.0 million, respectively. We expect to make benefit payments under this plan during fiscal 2007 of $10.3 million. For fiscal 2006 and 2005, we made cash contributions to our international pension plans of $25.7 million and $29.2 million, respectively. We expect to make contributions under these plans during fiscal 2007 of $18.8 million. In addition, at June 30, 2006 and 2005, we recognized a liability on our balance sheet for each pension plan if the fair market value of the assets of that plan was less than the accumulated benefit obligation and, accordingly, a benefit or a charge was recorded in accumulated other comprehensive income (loss) in shareholders' equity for the change in such liability. During fiscal 2006, we recorded a benefit, net of deferred tax, of $29.9 million while in fiscal 2005, we recorded a charge, net of deferred tax, of $11.4 million to accumulated other comprehensive income (loss).
Commitments and Contingencies For additional contingencies, refer to "Legal Proceedings" in Note 14 of Notes to Consolidated Financial Statements.
Contractual Obligations
Derivative Financial Instruments and Hedging Activities For each derivative contract entered into where we look to obtain special hedge accounting treatment, we formally document the relationship between the hedging instrument and hedged item, as well as its risk-management objective and strategy for undertaking the hedge, the nature of the risk being hedged, how the hedging instruments' effectiveness in offsetting the hedged risk will be assessed prospectively and retrospectively, and a description of the method of measuring ineffectiveness. This process includes linking all derivatives that are designated as fair-value, cash-flow, or foreign-currency hedges to specific assets and liabilities on the balance sheet or to specific firm commitments or forecasted transactions. We also formally assess, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. If it is determined that a derivative is not highly effective, then we will be required to discontinue hedge accounting with respect to that derivative prospectively.
Foreign Exchange Risk Management As a matter of policy, we only enter into contracts with counterparties that have at least an "A" (or equivalent) credit rating. The counterparties to these contracts are major financial institutions. We do not have significant exposure to any one counterparty. Our exposure to credit loss in the event of nonperformance by any of the counterparties is limited to only the recognized, but not realized, gains attributable to the contracts. Management believes risk of default under these hedging contracts is remote and in any event would not be material to the consolidated financial results. The contracts have varying maturities through the end of June 2007. Costs associated with entering into such contracts have not been material to our consolidated financial results. We do not utilize derivative financial instruments for trading or speculative purposes. At June 30, 2006, we had foreign currency contracts in the form of forward exchange contracts and option contracts in the amount of $782.6 million and $130.2 million, respectively. The foreign currencies included in forward exchange contracts (notional value stated in U.S. dollars) are principally the Euro ($238.5 million), Swiss franc ($98.5 million), British pound ($92.4 million), Canadian dollar ($71.7 million), Japanese yen ($50.6 million), Australian dollar ($50.5 million) and South Korean won ($33.1 million). The foreign currencies included in the option contracts (notional value stated in U.S. dollars) are principally the Japanese yen ($32.0 million), Euro ($27.7 million), Canadian dollar ($22.8 million), Swiss franc ($14.8 million) and South Korean won ($13.4 million).
Interest Rate Risk Management We have an interest rate swap agreement with a notional amount of $250.0 million to effectively convert fixed interest on the existing $250.0 million 6% Senior Notes to variable interest rates based on six-month LIBOR. We designated the swap as a fair-value hedge. As of June 30, 2006, the fair-value hedge was highly effective, in all material respects.
Market Risk Our calculated value-at-risk exposure represents an estimate of reasonably possible net losses that would be recognized on our portfolio of derivative financial instruments assuming hypothetical movements in future market rates and is not necessarily indicative of actual results, which may or may not occur. It does not represent the maximum possible loss or any expected loss that may occur, since actual future gains and losses will differ from those estimated, based upon actual fluctuations in market rates, operating exposures, and the timing thereof, and changes in our portfolio of derivative financial instruments during the year. We believe, however, that any such loss incurred would be offset by the effects of market rate movements on the respective underlying transactions for which the derivative financial instrument was intended.
OFF-BALANCE SHEET ARRANGEMENTS
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