-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QnKJ1mDi8OCCRNht6iVtfJTpaTskKeHt+Fafipxt/apeBFs5MWlWdH51FAETs/YH fVcubRAGUhgvuxvWHNGbRw== 0000950144-99-005642.txt : 19990513 0000950144-99-005642.hdr.sgml : 19990513 ACCESSION NUMBER: 0000950144-99-005642 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990328 FILED AS OF DATE: 19990512 FILER: COMPANY DATA: COMPANY CONFORMED NAME: PARAGON TRADE BRANDS INC CENTRAL INDEX KEY: 0000889429 STANDARD INDUSTRIAL CLASSIFICATION: CONVERTED PAPER & PAPERBOARD PRODS (NO CONTAINERS/BOXES) [2670] IRS NUMBER: 911554663 STATE OF INCORPORATION: DE FISCAL YEAR END: 1230 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 001-11368 FILM NUMBER: 99617803 BUSINESS ADDRESS: STREET 1: 180 TECHNOLOGY PARLWAY CITY: NORCROSS STATE: GA ZIP: 30092 BUSINESS PHONE: 6789695000 MAIL ADDRESS: STREET 1: 180 TECHNOLOGY PKWY CITY: NORCROSS STATE: GA ZIP: 30092 10-Q 1 PARAGON TRAD BRANDS INC 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the thirteen week period ended March 28, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________ to ____________ Commission File No. 1-11368 PARAGON TRADE BRANDS, INC. (Exact name of registrant as specified in its charter) Delaware 91-1554663 --------------------------------- ------------------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 180 Technology Parkway Norcross, Georgia 30092 -------------------------------------------- (Address of principal executive offices) (678) 969-5000 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- The number of shares outstanding of the registrant's common stock was 11,946,226 shares ($.01 par value) as of March 28, 1999. Page 1 Exhibit Index on Page 42 2 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES INDEX TO FORM 10-Q FILING FOR THE THIRTEEN WEEK PERIOD ENDED MARCH 28, 1999
Page No. -------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements 3 Consolidated Statements of Operations 3 Consolidated Balance Sheets 4 Consolidated Statements of Cash Flows 5 Notes to Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of 21 Operations Item 3. Quantitative and Qualitative Disclosure about Market Risk 31 PART II. OTHER INFORMATION Item 1. Legal Proceedings 31 Item 2. Changes in Securities (not applicable) Item 3 Defaults in Senior Securities 37 Item 4. Submission of Matters to a Vote of Security Holders (not applicable) Item 5. Other Information (not applicable) Item 6. Exhibits and Reports on Form 8-K 37 Signature Page 41 Exhibit Index 42 Exhibits 46
-2- 3 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLAR AMOUNTS IN THOUSANDS EXCEPT PER SHARE DATA) (NOTE 2)
Thirteen Weeks Ended -------------------- March 28, 1999 March 29, 1998 -------------- -------------- Sales, net of discounts and allowances .......... $ 126,244 $ 138,297 Cost of sales ................................... 109,537 110,799 --------- --------- Gross profit .................................... 16,707 27,498 Selling, general and administrative expense ..... 21,443 19,052 Research and development expense ................ 1,008 1,402 --------- --------- Operating profit (loss) ......................... (5,744) 7,044 Equity in earnings of unconsolidated subsidiaries 371 924 Interest expense(1) ............................. 102 290 Other income .................................... 496 424 --------- --------- Earnings (loss) before income taxes and bankruptcy costs ....................... (4,979) 8,102 Bankruptcy costs ................................ 1,927 1,646 Provision for income taxes ...................... 313 450 --------- --------- Net earnings (loss) ............................. $ (7,219) $ 6,006 ========= ========= Basic earnings (loss) per common share .......... $ (.60) $ .50 ========= ========= Diluted earnings (loss) per common share ........ $ (.60) $ .50 ========= ========= Dividends paid .................................. $ -- $ -- ========= ========= (1)Contractual Interest ......................... $ 1,335 $ 1,550 ========= =========
See Accompanying Notes to Financial Statements -3- 4 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) CONSOLIDATED BALANCE SHEETS (DOLLAR AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) (NOTE 2)
March 28, 1999 December 27, 1998 -------------- ----------------- ASSETS Cash and short-term investments......................... $ 25,274 $ 22,625 Receivables............................................. 59,324 79,156 Inventories............................................. 51,999 53,282 Current portion of deferred income taxes................ 3,334 4,260 Prepaid expenses........................................ 5,082 4,323 ------------ ------------ Total current assets............................... 145,013 163,646 Property and equipment.................................. 102,202 106,200 Construction in progress................................ 28,003 19,626 Assets held for sale.................................... 1,463 4,691 Investment in unconsolidated subsidiary, at cost........ 22,743 22,743 Investment in and advances to unconsolidated subsidiaries, at equity............................ 67,537 66,041 Goodwill 32,340 32,819 Other assets............................................ 13,308 13,521 ------------ ------------ Total assets ...................................... $ 412,609 $ 429,287 ============ ============ LIABILITIES AND SHAREHOLDERS' DEFICIT Checks issued but not cleared........................... $ 8,014 $ 12,433 Accounts payable........................................ 32,264 32,416 Accrued liabilities..................................... 29,994 33,646 ------------ ------------ Total current liabilities............................... 70,272 78,495 Liabilities subject to compromise (Note 9).............. 406,527 406,859 Deferred income taxes................................... 4,797 5,773 ------------ ------------ Total liabilities.................................. 481,596 491,127 Commitments and contingencies (Notes 1 and 11) Shareholders' deficit: Preferred stock: Authorized 10,000,000 shares, no shares issued, $.01 par value................... -- -- Common stock: Authorized 25,000,000 shares, issued 12,384,975 and 12,378,616 shares, $.01 par value............................. 124 124 Capital surplus......................................... 143,728 143,918 Accumulated other comprehensive loss.................... (1,532) (1,840) Retained deficit........................................ (200,977) (193,758) Less: Treasury stock, 438,750 and 429,696 shares, at cost (10,330) (10,284) ------------ ------------ Total shareholders' deficit........................ (68,987) (61,840) ------------ ------------ Total liabilities and shareholders' deficit........ $ 412,609 $ 429,287 ============ ============
See Accompanying Notes to Financial Statements. -4- 5 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLAR AMOUNTS IN THOUSANDS) (NOTE 2)
Thirteen Weeks Ended -------------------- March 28, 1999 March 29, 1998 -------------- -------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings (loss) ............................. $ (7,219) $ 6,006 Non-cash charges (benefits) to earnings: Depreciation and amortization .............. 8,436 8,494 Deferred income taxes ...................... (50) (34) Equity in earnings of unconsolidated subsidiaries ........................... (370) (602) Changes in operating assets and liabilities: Accounts receivable ........................ 16,988 535 Inventories and prepaid expenses ........... 524 (130) Accounts payable ........................... (152) 25,506 Checks issued but not cleared .............. (4,419) (4,999) Pre-petition reclamation payment authorized by court .................... (332) -- Accrued liabilities ........................ (3,888) 1,142 Other ........................................... (782) (1,812) -------- -------- Net cash provided by operating activities... 8,736 34,106 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Expenditures for property and equipment ......... (11,085) (3,411) Proceeds from sale of property and equipment .... 4,800 3,408 Proceeds from sale of Changing Paradigms, Inc.... 350 -- Investment in and advances to unconsolidated subsidiaries, at equity .................... (800) (2,488) Other ........................................... 648 (2,036) -------- -------- Net cash used by investing activities ...... (6,087) (4,527) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in short-term borrowings ........... -- 470 -------- -------- Net cash provided by financing activities ............................ -- 470 -------- -------- NET INCREASE IN CASH ............................ 2,649 30,049 Cash at beginning of period ..................... 22,625 991 -------- -------- Cash at end of period ........................... $ 25,274 $ 31,040 ======== ======== Cash paid (received) during the period for: Interest, net of amounts capitalized ....... $ 102 $ 1,010 ======== ======== Income taxes ............................... $ 464 $ 840 ======== ======== Bankruptcy costs ........................... $ 1,323 $ 413 ======== ========
See Accompanying Notes to Financial Statements. -5- 6 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS FOR THE THIRTEEN WEEK PERIOD ENDED MARCH 29, 1998 (DOLLAR AMOUNTS IN THOUSANDS EXCEPT SHARE AND PER SHARE DATA) NOTE 1: CHAPTER 11 PROCEEDINGS On January 6, 1998, Paragon Trade Brands, Inc. ("Paragon" or the "Company") filed for relief under Chapter 11 of the United States Bankruptcy Code (the "Chapter 11 filing"), in the United States Bankruptcy Court for the Northern District of Georgia. The Company is currently operating as a debtor-in-possession under the Bankruptcy Code. The Procter & Gamble Company ("P&G") had filed a lawsuit against the Company in the United States District Court for the District of Delaware, alleging that the Company's disposable baby diaper products infringed two of P&G's dual cuff diaper patents. The lawsuit sought injunctive relief, lost profit and royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by P&G. On December 30, 1997, the District Court issued a Judgment and Opinion finding that P&G's dual cuff diaper patents were valid and infringed by certain of the Company's disposable diaper products, while also rejecting the Company's patent infringement claims against P&G. The District Court had earlier dismissed the Company's antitrust counterclaim on summary judgment. The Judgment entitled P&G to damages based on sales of the Company's diapers containing the "inner-leg gather" feature. While the final damages number of approximately $178,400 was not entered by the District Court until June 2, 1998, the Company originally estimated the liability and associated litigation costs to be approximately $200,000. The amount of the award resulted in violation of certain covenants under the Company's then-existing bank loan agreements. As a result, the issuance of the Judgment and the uncertainty it created caused an immediate and critical liquidity issue for the Company. The Chapter 11 filing was designed to prevent P&G from placing liens on Company property, permit the Company to appeal the Delaware District Court's decision on the P&G case in an orderly fashion and give the Company the opportunity to resolve liquidated and unliquidated claims against the Company which arose prior to the Chapter 11 filing. Substantially all liabilities outstanding as of the date of the Chapter 11 filing are subject to resolution under a plan of reorganization to be voted upon by those of the Company's creditors and shareholders entitled to vote and confirmed by the Bankruptcy Court. Schedules were filed by the Company on March 3, 1998 with the Bankruptcy Court setting forth the assets and liabilities of the Company as of the date of the Chapter 11 filing, as shown by the Company's accounting records. Amended schedules were filed by the Company on March 30, 1998 with the Bankruptcy Court. The Bankruptcy Court set a bar date of June 5, 1998 by which time creditors must have filed proofs of claim setting forth any claims which arose prior to the Chapter 11 filing. On February 2, 1999, the Company entered into a Settlement Agreement with P&G which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Delaware Judgment, the Company's appeal of the Delaware Judgment, P&G's motion to find the Company in contempt of the Delaware Judgment and P&G's proof of claim filed in the Company's Chapter 11 reorganization proceeding. As a part of the P&G settlement, Paragon grants P&G an allowed unsecured prepetition claim of $158,500 and an allowed administrative claim of $5,000. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to certain of the patents asserted by P&G in its proof of claim, including those asserted in the Delaware Action. The U.S. and Canadian patent rights licensed by the Company will allow the Company to manufacture a dual cuff baby diaper design. In exchange for these rights, the Company has agreed to pay P&G running royalties on net sales of the licensed products equal to 2 percent through October 2005, .75 percent thereafter through October 2006 and .375 percent thereafter through March 2007 in the U.S.; and 2 percent through October 2008 and 1.25 percent thereafter through December 2009 in Canada. The Settlement Agreement also provides, among other things, that P&G will grant the Company and/or its affiliates "most favored licensee" status with respect to patents owned by P&G on the date of the Settlement Agreement or for which an application was pending on that date. In addition, the Company has agreed with P&G that prior to litigating any future patent dispute, the parties will engage in good faith negotiations and will consider arbitrating the dispute before resorting to litigation. -6- 7 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) The Company believes that the royalty rates being charged by P&G, together with royalties to be paid to Kimberly-Clark Corporation ("K-C") described below, will have a material adverse impact on the Company's future financial condition and results of operations. Under the terms of the P&G Settlement Agreement, the Company and P&G jointly requested modification of the injunction entered in Delaware District Court so as to allow the Company to begin converting to a dual cuff design pursuant to the License Agreements described above. The injunction was modified as requested on February 22, 1999 and the product conversion is complete. As also provided under the terms of the P&G Settlement Agreement, once a Final Order, as defined therein, has been entered by the Bankruptcy Court approving the settlement, the Company will withdraw with prejudice its appeal of the Delaware Judgment to the Federal Circuit, and P&G will withdraw with prejudice its motion in Delaware District Court to find the Company in contempt of the Delaware Judgment. A hearing on the Company's motion to seek approval from the Bankruptcy Court of this settlement was commenced on March 22 and 23, 1999 and resumed on April 13, 14 and 15, 1999. Closing arguments have been scheduled for June 8, 1999. Both the Official Committee of Equity Security Holders and K-C have objected to the P&G settlement. The Company intends to continue to pursue approval of the P&G Settlement by the Bankruptcy Court. Should the P&G Settlement Agreement not be approved by a Final Order of the Bankruptcy Court by July 31, 1999, however, the License Agreements described above will become terminable at P&G's option. The Company cannot predict when, or if, such approval will be granted. On October 26, 1995, K-C filed a lawsuit against the Company in U.S. District Court in Dallas, Texas, alleging infringement by the Company's products of two K-C patents relating to dual cuffs. The lawsuit sought injunctive relief, royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by K-C. In addition, K-C sued the Company on another patent issued to K-C which is based upon a further continuation of one of the K-C dual cuff patents asserted in the case. On March 19, 1999, the Company entered into a Settlement Agreement with K-C which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Texas action, including the Company's counterclaims, and K-C's proof of claim filed in the Company's Chapter 11 reorganization proceeding. Under the terms of the K-C Settlement Agreement, the Company grants K-C an allowed unsecured prepetition claim of $110,000 and an allowed administrative claim of $5,000. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to the patents asserted by K-C in the Texas action. The patent rights licensed by the Company from K-C will allow the Company to manufacture a dual cuff diaper design. In exchange for these patent rights, the Company has agreed to pay K-C annual running royalties on net sales of the licensed products in the U.S. and Canada equal to: 2.5 percent of the first $200,000 of net sales of the covered diaper products and 1.5 percent of such net sales in excess of $200,000 in each calendar year commencing January 1999 through November 2004. The Company has agreed to pay a minimum annual royalty for diaper sales of $5,000, but amounts due on the running royalties will be offset against this minimum. The Company will also pay K-C running royalties of 5 percent of net sales of covered training pant products for the same period, but there is no minimum royalty for training pants. As part of the settlement, the Company has granted a royalty-free license to K-C for three patents which the Company in the Texas action claimed K-C infringed. The Company believes that these royalties will, together with royalties to be paid to P&G described above, have a material adverse impact on the Company's future financial condition and results of operations. As a part of the K-C License Agreement, K-C has agreed not to sue the Company on two of K-C's patents related to the use of super-absorbent polymers ("SAP") in diapers and training pants, so long as the Company uses SAP which exhibits certain performance characteristics (the "SAP Safe Harbor"). The Company has experienced certain product performance issues the Company believes may be related to such SAP. As a result, the Company expects that it will incur increased marketing and selling, general and administrative expenses ("SG&A") expenditures in 1999 to address product performance issues. These increased expenditures are expected to have a material adverse impact on the Company's financial position and results of operations in 1999. The Company is encountering increased product costs due to the increased price and usage of the new SAP. While the Company is working diligently with its SAP suppliers to develop a better performing alternative -7- 8 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) which is still within the SAP Safe Harbor, the Company cannot predict at this time whether or when such an alternative SAP would be available. The Company expects that these increased product costs will have a material adverse impact on its financial condition and results of operations for at least 1999 and potentially beyond. Upon the Effective Date, as defined in the K-C Settlement Agreement, K-C will dismiss with prejudice its complaint in the Texas action, as well as its related filings in the District Court in Georgia, and the Company will simultaneously dismiss with prejudice its counterclaims in the Texas action. The Company has filed a motion with the Bankruptcy Court to seek approval of the settlement and a hearing date has been set for June 9, 10 and 11, 1999. If the K-C Settlement Agreement is not approved by an order of the Bankruptcy Court entered before August 1, 1999, the K-C License Agreement described above will terminate automatically. The ability of the Company to effect a successful reorganization will depend, in significant part, upon the Company's ability to formulate a plan of reorganization that is approved by the Bankruptcy Court and meets the standards for plan confirmation under the Bankruptcy Code. The Company cannot predict at this time the effect of the material adverse impact related to the increased costs described above on the Company's enterprise valuation and on a plan of reorganization for the Company. The Company believes, however, that it may not be possible to satisfy in full all of the claims against the Company. As a result of the Chapter 11 filing, the Company has incurred and will continue to incur significant costs for professional fees as the reorganization plan is developed. The Company is also required to pay certain expenses of the Official Committee of Unsecured Creditors (the "Creditors' Committee") and the Official Committee of Equity Security Holders (the "Equity Committee" and together with the Creditors' Committee, the "Committees"), including professional fees, to the extent allowed by the Bankruptcy Court. The License Agreements with each of P&G and K-C provide that if the related Settlement Agreements are not approved, as specified in each respective agreement, by July 31, 1999 and August 1, 1999, respectively, the P&G License Agreements will become terminable at P&G's option and the K-C License Agreement will terminate automatically. If the P&G and K-C License Agreements are terminated because the respective Settlement Agreements are not approved in a timely manner, the Company could be faced with having to convert to a diaper design other than the dual cuff design covered by the licenses. At this time, the Company's only viable alternative product design is the single cuff product which is the subject of P&G's Contempt Motion in Delaware. While the Company intends to vigorously pursue approval of both settlements, it cannot predict when, or if, such approval will be granted. The Chapter 11 filing did not include the Company's wholly owned subsidiaries including Paragon Trade Brands (Canada) Inc., Paragon Trade Brands International, Inc., Paragon Trade Brands FSC, Inc. and Changing Paradigms, Inc., which was sold in October of 1998. The following information summarizes the combined results of operations for the thirteen-week periods ended March 28, 1999 and March 29, 1998, as well as the combined balance sheets as of March 28, 1999 and December 27, 1998 for these subsidiaries. This information has been prepared on the same basis as the consolidated financial statements.
Thirteen Weeks Ended -------------------- March 28, 1999 March 29, 1998 -------------- -------------- Sales, net of discounts and allowances................ $ 8,467 $ 14,802 Gross profit.......................................... $ 1,174 $ 2,431 Earnings before income taxes.......................... $ 1,547 $ 2,148 Net earnings.......................................... $ 1,284 $ 1,664
-8- 9 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED)
March 28, 1999 December 27, 1998 -------------- ----------------- Current assets........................................ $ 17,444 $ 17,863 Non-current assets.................................... $ 55,657 $ 54,734 Current liabilities................................... $ 4,710 $ 5,700 Non-current liabilities............................... $ 8,427 $ 8,495
NOTE 2: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING AND REPORTING POLICIES Basis of Presentation The consolidated financial statements include the accounts of Paragon Trade Brands, Inc. and its wholly-owned subsidiaries. All significant intercompany transactions and accounts have been eliminated. The accompanying consolidated balance sheet as of December 27, 1998, which has been derived from audited financial statements, and the unaudited interim consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information presented not misleading. It is suggested that these consolidated financial statements be read in conjunction with the financial statements and the notes thereto included in the Company's latest annual report on Form 10-K. In the opinion of management, all adjustments necessary for a fair statement of the results of the interim periods have been included. All such interim adjustments are of a normal recurring nature except for the bankruptcy-related costs. The results of operations for the thirteen week period ending March 28, 1999 should not be regarded as necessarily indicative of the results that may be expected for the full year. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As more fully described in Notes 1 and 11, the Company is unable to predict when it will submit a plan of reorganization that will be acceptable to the Bankruptcy Court. In the event a plan of reorganization is confirmed and consummated, continuation of the business thereafter is dependent on the Company's ability to successfully execute the underlying business plan. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. New Accounting Standards In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This statement requires capitalization of certain costs of internal-use software. The Company adopted this statement in the quarter ended March 28, 1999, and it did not have a material impact on the financial statements. In April 1998, the AICPA issued Statement of Position 98-5, "Reporting on the Costs of Start-up Activities." This statement requires that the costs of start-up activities and organizational costs be expensed as incurred. Any of these costs previously capitalized by a company must be written off in the year of adoption. The Company adopted this statement in the quarter ended March 28, 1999, and the equity in earnings of unconsolidated subsidiaries included $519 in charges as a result of the adoption of the statement. -9- 10 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) Reclassifications Certain reclassifications have been made to the prior years' financial statements to conform them to the current year's presentation. NOTE 3: BANKRUPTCY COSTS Bankruptcy costs were directly associated with the Company's Chapter 11 reorganization proceedings and consisted of the following:
Thirteen Weeks Ended -------------------- March 28, 1999 March 29, 1998 -------------- -------------- Professional fees..................................... $ 1,897 $ 1,590 Amortization of DIP Credit Facility Deferred financing costs......................... 204 -- Other................................................. 1 88 Interest Income....................................... (175) (32) -------------- -------------- $ 1,927 $ 1,646 ============== ==============
NOTE 4: INCOME TAXES Income tax expense for the subsidiaries not included in the Chapter 11 filing was $313 and $450 during the periods ended March 28, 1999 and March 29, 1998, respectively. The Company recorded an income tax benefit of approximately $3,000 during the period ended March 28, 1999, which was offset by an increase in the valuation allowances with respect to its net deferred and other tax-related assets as realization is dependent upon sufficient taxable income in the future. The Company recorded income tax expense of approximately $1,800 during the period ended March 29, 1998, which was offset by a reduction in the valuation allowances. NOTE 5: COMPREHENSIVE INCOME (LOSS) The following are the components of comprehensive income (loss):
Thirteen Weeks Ended -------------------- March 28, 1999 March 29, 1998 -------------- -------------- Net income (loss)..................................... $ (7,219) $ 6,006 Foreign currency translation adjustment............... 308 12 ----------- ----------- Comprehensive income (loss)........................... $ (6,911) $ 6,018 =========== ===========
NOTE 6: RECEIVABLES Receivables consist of the following:
March 28, 1999 December 27, 1998 -------------- ----------------- Accounts receivable - trade........................... $ 57,614 $ 71,079 Other receivables..................................... 12,658 16,777 ----------- ----------- 70,272 87,856 Less: Allowance for doubtful accounts................ (10,948) (8,700) ----------- ----------- Net receivables....................................... $ 59,324 $ 79,156 ----------- -----------
-10- 11 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED)
NOTE 7: INVENTORIES Inventories consist of the following: March 28, 1999 December 27, 1998 -------------- ----------------- LIFO: Raw materials - pulp......................... $ 295 $ 232 Finished goods............................... 28,010 31,417 FIFO: Raw materials - other........................ 8,196 7,346 Materials and supplies....................... 21,821 20,924 ----------- ----------- 58,322 59,919 Reserve for excess and obsolete items........................... (6,323) (6,637) ----------- ----------- Net inventories....................................... $ 51,999 $ 53,282 =========== ===========
NOTE 8: ACCRUED LIABILITIES Accrued liabilities are as follows:
March 28, 1999 December 27, 1998 -------------- ----------------- Payroll - wages and salaries, incentive awards, retirement, vacation and severance pay........... $ 10,196 $ 16,977 Coupons and promotions................................ 6,806 5,994 Royalties............................................. 3,836 718 Other................................................. 9,156 9,957 ----------- ----------- Total................................................. $ 29,994 $ 33,646 =========== ===========
NOTE 9: LIABILITIES SUBJECT TO COMPROMISE Liabilities subject to compromise under the Company's reorganization proceeding include substantially all current and long-term unsecured debt as of the date of the Chapter 11 filing. Pursuant to the Bankruptcy Code, payment of these liabilities may not be made except pursuant to a plan of reorganization or Bankruptcy Court order while the Company continues to operate as a debtor-in-possession. The Company has received approval from the Bankruptcy Court to pay or otherwise honor certain of its prepetition obligations including a portion of short-term borrowings, claims subject to reclamation and employee wages, benefits and expenses. Liabilities subject to compromise are comprised of the following:
March 28, 1999 December 27, 1998 -------------- ----------------- Accrued settlement contingency........................ $ 278,500 $ 278,500 Bank debt............................................. 81,397 81,397 Accounts payable...................................... 39,420 39,752 Accrued liabilities .................................. 5,920 5,920 Deferred compensation................................. 1,290 1,290 ----------- ----------- $ 406,527 $ 406,859 =========== ===========
-11- 12 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) NOTE 10: EARNINGS PER COMMON SHARE Following is a reconciliation of the numerators and denominators of the basic and diluted earnings (loss) per common share:
Thirteen Weeks Ended -------------------- March 28, 1999 March 29, 1998 -------------- -------------- Net earnings (loss) ........................ $(7,219) $ 6,006 ======= ======= Weighted average number of common shares used in basic EPS (000's) ..... 11,950 11,934 Effect of dilutive securities: Stock options (000's) ................ -- -- ------- ------- Weighted average number of common shares and potentially dilutive common stock in dilutive EPS (000's) ........ 11,950 11,934 ======= ======= Basic earnings (loss) per common share ..... $ (.60) $ .50 ======= ======= Diluted earnings (loss) per common share ... $ (.60) $ .50 ======= =======
Options to purchase 687,247 and 760,853 shares of common stock outstanding during the periods ending March 28, 1999 and March 29, 1998, respectively, were not included in the calculation because the options' exercise price was greater than the average market price of the common shares. Diluted and basic earnings (loss) per share are the same for the periods ended March 28, 1999 and March 29, 1998 because the computation of diluted earnings (loss) per share was anti-dilutive. NOTE 11: LEGAL PROCEEDINGS The Procter & Gamble Company v. Paragon Trade Brands, Inc. - P&G filed a lawsuit in January 1994 in the District Court for the District of Delaware alleging that the Company's "Ultra" infant disposable diaper products infringed two of P&G's dual cuff diaper patents. The lawsuit sought injunctive relief, lost profit and royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by P&G. In March 1996, the District Court granted P&G's motion for summary judgment to dismiss the Company's antitrust counterclaim. The trial was completed in February 1997, the parties submitted post-trial briefs and closing arguments were conducted on October 22, 1997. Legal fees and costs for this litigation have been significant. On December 30, 1997, the Delaware District Court issued a Judgment and Opinion finding that P&G's dual cuff patents were valid and infringed, while at the same time finding the Company's patent to be invalid, unenforceable and not infringed by P&G's products. Judgment was entered on January 6, 1998. Damages of approximately $178,400 were entered against Paragon by the District Court on June 2, 1998. At the same time, the District Court entered injunctive relief agreed upon by P&G and the Company. The Company had previously filed with the District Court a motion under Rule 59 for a new trial or to alter or amend the Judgment. The District Court denied Paragon's motion by order entered August 4, 1998. The District Court also denied a motion by P&G seeking to recover attorneys' fees it expended in defending itself against Paragon's patent infringement counterclaim. On August 4, 1998, the Company filed with the Federal Circuit Court of Appeals its amended notice of appeal. The appeal was fully briefed, and oral argument was scheduled for February 5, 1999. -12- 13 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) On September 22, 1998, P&G filed a motion in the Delaware District Court seeking to have the Court find Paragon in contempt of the injunction entered in the case on account of Paragon's manufacture and sale of its single cuff diaper product. P&G asserted in its claim that Paragon's single cuff diaper design (i) is no more than just colorably different from the design found to infringe the P&G patents at issue in the case and (ii) also infringes such patents. The Company opposed P&G's motion. Based on the advice of counsel, the Company believes that P&G's motion is without merit. If the motion were granted, however, the Company would be forced to discontinue the manufacture and sale of its single cuff design. In addition, P&G in its motion asked that the Court order the Company to send letters to all of its customers advising them that the continued resale by them of its single cuff design would also constitute patent infringement. Consequently, the Company believes that if the motion were granted it would have a material adverse effect on the Company's financial condition and results of operations and would seriously jeopardize the Company's future viability. The Judgment has had a material adverse effect on the Company's financial position and its results of operations. As a result of the District Court's Judgment, the Company filed for relief under Chapter 11 of the Bankruptcy Code, 11 U.S.C. Section 101 et seq., in the United States Bankruptcy Court for the Northern District of Georgia (Case No. 98-60390) on January 6, 1998. See "--In Re Paragon Trade Brands, Inc.," below. P&G filed alleged claims in the Company's Chapter 11 reorganization proceeding ranging from approximately $2,300,000 (without trebling) to $6,500,000 (with trebling), which included a claim of $178,400 for the Delaware judgment. See "--In Re Paragon Trade Brands, Inc.," below. The remaining claims include claims for, among other things, alleged patent infringement by the Company in foreign countries where it has operations. On February 2, 1999, the Company entered into a Settlement Agreement with P&G which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Delaware Judgment, the Company's appeal of the Delaware Judgment, P&G's motion to find the Company in contempt of the Delaware Judgment and P&G's proof of claim filed in the Company's Chapter 11 reorganization proceeding. As a part of the P&G settlement, Paragon grants P&G an allowed unsecured prepetition claim of $158,500 and an allowed administrative claim of $5,000. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to certain of the patents asserted by P&G in its proof of claim, including those asserted in the Delaware Action. The U.S. and Canadian patent rights licensed by the Company will allow the Company to manufacture a dual cuff baby diaper design. In exchange for these rights, the Company has agreed to pay P&G running royalties on net sales of the licensed products equal to 2 percent through October 2005, .75 percent thereafter through October 2006 and .375 percent thereafter through March 2007 in the U.S.; and 2 percent through October 2008 and 1.25 percent thereafter through December 2009 in Canada. The Settlement Agreement also provides, among other things, that P&G will grant the Company and/or its affiliates "most favored licensee" status with respect to patents owned by P&G on the date of the Settlement Agreement or for which an application was pending on that date. In addition, the Company has agreed with P&G that prior to litigating any future patent dispute, the parties will engage in good faith negotiations and will consider arbitrating the dispute before resorting to litigation. The Company believes that the royalty rates being charged by P&G, together with royalties to be paid to K-C described above, will have a material adverse impact on the Company's future financial condition and results of operations. Under the terms of the P&G Settlement Agreement, the Company and P&G jointly requested modification of the injunction entered in Delaware District Court so as to allow the Company to begin converting to a dual cuff design pursuant to the License Agreements described above. The injunction was modified as requested on February 22, 1999 and the product conversion is complete. As also provided under the terms of the P&G Settlement Agreement, once a Final Order, as defined therein, has been entered by the Bankruptcy Court approving the settlement, the Company will withdraw with prejudice its appeal of the Delaware Judgment to the Federal Circuit, and P&G will withdraw with prejudice its motion in Delaware District Court to find the Company in contempt of the Delaware Judgment. A hearing on the Company's motion to seek approval from the Bankruptcy Court of this settlement was commenced on March 22 and 23, 1999 and resumed on April 13, 14 and 15, 1999. Closing arguments have been scheduled for June 8, 1999. Both the Equity Committee and K-C have objected to the P&G settlement. The Company intends to continue to pursue approval of the P&G Settlement by the -13- 14 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) Bankruptcy Court. Should the P&G Settlement Agreement not be approved by a Final Order of the Bankruptcy Court by July 31, 1999, however, the License Agreements described above will become terminable at P&G's option. The Company cannot predict when, or if, such approval will be granted. Kimberly-Clark Corporation v. Paragon Trade Brands, Inc. -- On October 26, 1995, K-C filed a lawsuit against the Company in U.S. District Court in Dallas, Texas, alleging infringement by the Company's products of two K-C patents relating to dual cuffs. The lawsuit sought injunctive relief, royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by K-C. Several pre-trial motions were filed by each party, including a motion for summary judgment filed by K-C with respect to the Company's antitrust counterclaim and a motion for summary judgment filed by the Company on one of the patents asserted by K-C. In addition, K-C sued the Company on another patent issued to K-C which is based upon a further continuation of one of the K-C dual cuff patents asserted in the case. That action was consolidated with the pending action. The Court appointed a special master to rule on the various pending motions. Legal fees and costs in connection with this litigation have been significant. As a result of the Company's Chapter 11 filing, the proceedings in the K-C litigation were stayed. The Bankruptcy Court issued an order on April 10, 1998 permitting, among other things, a partial lifting of the stay to allow the issuance of the special master's report on the items under his consideration. K-C filed with the Bankruptcy Court a motion for reconsideration of the Bankruptcy Court's April 10, 1998 order, which was denied on June 15, 1998. K-C has appealed this denial of reconsideration to the District Court for the Northern District of Georgia. The Company objected to K-C's Appeal and sought to have it dismissed. K-C also filed a motion with the District Court in Atlanta to withdraw the reference with respect to all matters pertaining to its proof of claim from the jurisdiction of the Bankruptcy Court. By order executed February 18, 1999, the appeal, K-C's motion for withdrawal of the reference and the Company's motion to dismiss the appeal were dismissed by the District Court without prejudice to the right of either party within sixty days to re-open the actions if a settlement was not consummated. See "--In Re Paragon Trade Brands, Inc." below. On May 26, 1998, the special master issued his report on the majority of the motions pending before him. His report included a finding, among other things, that Paragon, as the successor-in-interest to the disposable diaper business of Pope & Talbot, has a fully paid-up license to one of the three asserted K-C inner-leg gather patents, which license runs from the date of the acquisition by the Company of Pope & Talbot. Pope & Talbot had previously obtained the license from K-C. The special master also found that K-C should be held to the narrow interpretation of its patent applied by Judge Dwyer in the Western District of Washington in earlier litigation between P&G and K-C on the patent. In addition, the special master also recommended that the Company's antitrust counterclaim and any discovery-related matters in connection therewith be dismissed. Effective September 1, 1998, the Texas action was reassigned to Judge Lindsey, a newly-appointed judge on the Dallas District Court bench. Judge Lindsey asked the parties to report on the status of the case and the likelihood of settlement. The parties responded on November 6, 1998, that negotiations were underway and that they believed considerable progress was being made. The Company has previously disclosed that should K-C prevail on its claims, an award of all or a substantial portion of the relief requested by K-C could have a material adverse effect on the Company's financial condition and its results of operations. Based on the advice of patent counsel, the Company believes that the Company's products do not infringe any valid patent asserted by K-C. K-C filed alleged claims in the Company's Chapter 11 reorganization proceeding ranging from approximately $893,000 (without trebling) to $2,300,000 (with trebling). See "--In Re Paragon Trade Brands, Inc.," below. On March 19, 1999, the Company entered into a Settlement Agreement with K-C which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Texas action, including the Company's counterclaims, and K-C's proof of claim filed in the Company's Chapter 11 reorganization proceeding. Under the terms of the K-C Settlement Agreement, the Company grants K-C an allowed unsecured prepetition claim of $110,000 and an allowed administrative claim of $5,000. As a part of the settlement, the Company has entered -14- 15 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to the patents asserted in the Texas action. The patent rights licensed by the Company from K-C will allow the Company to manufacture a dual cuff diaper design. In exchange for these patent rights, the Company has agreed to pay K-C annual running royalties on net sales of the licensed products in the U.S. and Canada equal to: 2.5 percent of the first $200,000 of net sales of the covered diaper products and 1.5 percent of such net sales in excess of $200,000 in each calendar year commencing January 1999 through November 2004. The Company has agreed to pay a minimum annual royalty for diaper sales of $5,000, but amounts due on the running royalties will be offset against this minimum. The Company will also pay K-C running royalties of 5 percent of net sales of covered training pant products for the same period, but there is no minimum royalty for training pants. As part of the settlement, the Company has granted a royalty-free license to K-C for three patents which the Company in the Texas action claimed K-C infringed. The Company believes that the overall effective royalty rate that the Company will pay to K-C will, together with royalties to be paid to P&G described above, have a material adverse impact on the Company's future financial condition and results of operations As a part of the K-C License Agreement, K-C has agreed not to sue the Company on two of K-C's patents related to the use of SAP in diapers and training pants, so long as the Company remains within the SAP Safe Harbor. The Company has experienced certain product performance issues the Company believes may be related to such SAP. As a result, the Company expects that it will incur increased marketing and SG&A expenditures in 1999 to address product performance issues. These increased expenditures are expected to have a material adverse impact on the Company's financial position and results of operations in 1999. The Company is encountering increased product costs due to the increased price and usage of the new SAP. While the Company is working diligently with its SAP supplier to develop a better performing alternative which is still within the SAP Safe Harbor, the Company cannot predict at this time whether or when such an alternative SAP would be available. The Company expects that these increased product costs will have a material adverse impact on its financial condition and results of operations for at least 1999 and potentially beyond. Upon the Effective Date, as defined in the K-C Settlement Agreement, K-C will dismiss with prejudice its complaint in the Texas action, as well as its related filings in the District Court in Georgia, and the Company will simultaneously dismiss with prejudice its counterclaims in the Texas action. The Company has filed a motion with the Bankruptcy Court to seek approval of the settlement and a hearing date has been set for June 9, 10 and 11, 1999. If the K-C Settlement Agreement is not approved by an order of the Bankruptcy Court entered before August 1, 1999, the K-C License Agreement described above will terminate automatically. The Company intends to vigorously pursue approval of the settlement but cannot predict when, or if, such approval will be granted. In Re Paragon Trade Brands, Inc. -- As described above, on December 30, 1997, the Delaware District Court issued a Judgment and Opinion in the Company's lawsuit with P&G which found, in essence, two of P&G's diaper patents to be valid and infringed by the Company's "Ultra" disposable baby diapers, while also rejecting the Company's patent infringement claim against P&G. Judgment was entered on January 6, 1998. While a final damages number was not entered by the District Court until June 2, 1998, the Company originally estimated the liability and associated litigation costs to be approximately $200,000. The amount of the award resulted in violation of certain covenants under the Company's bank loan agreements. As a result, the issuance of the Judgment and the uncertainty it created caused an immediate and critical liquidity issue for the Company which necessitated the Chapter 11 filing. Subsequently, damages of approximately $178,400 were entered against Paragon by the District Court on June 2, 1998. At the same time, the District Court entered injunctive relief agreed upon by P&G and the Company. See "--The Procter & Gamble Company v. Paragon Trade Brands, Inc.," above. -15- 16 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) The Chapter 11 filing prevented P&G from placing liens on the Company's assets, permitted the Company to appeal the District Court's decision in an orderly fashion and affords the Company the opportunity to resolve liquidated and unliquidated claims against the Company, which arose prior to the Chapter 11 filing. The Company is currently operating as a debtor-in-possession under the Bankruptcy Code. The bar date for the filing of proofs of claim (excluding administrative claims) by creditors was June 5, 1998. P&G filed alleged claims ranging from approximately $2,300,000 (without trebling) to $6,500,000 (with trebling), which included a claim of $178,400 for the Delaware judgment. See "--The Procter & Gamble Company v. Paragon Trade Brands, Inc.," above. The remaining claims include claims for, among other things, alleged patent infringement by the Company in foreign countries where it has operations. On February 2, 1999, the Company entered into a Settlement Agreement with P&G which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Delaware Judgment, the Company's appeal of the Delaware Judgment, P&G's motion to find the Company in contempt of the Delaware Judgment and P&G's proof of claim filed in the Company's Chapter 11 reorganization proceeding. As a part of the P&G settlement, Paragon grants P&G an allowed unsecured prepetition claim of $158,500 and an allowed administrative claim of $5,000. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to the patents asserted by P&G in its proof of claim, including those asserted in the Delaware Action. The U.S. and Canadian patent rights licensed by the Company will allow the Company to manufacture a dual cuff baby diaper design. In exchange for these rights, the Company has agreed to pay P&G running royalties on net sales of the licensed products equal to 2 percent through October 2005, .75 percent thereafter through October 2006 and .375 percent thereafter through March 2007 in the U.S.; and 2 percent through October 2008 and 1.25 percent thereafter through December 2009 in Canada. The Settlement Agreement also provides, among other things, that P&G will grant the Company and/or its affiliates "most favored licensee" status with respect to patents owned by P&G on the date of the Settlement Agreement or for which an application was pending on that date. In addition, the Company has agreed with P&G that prior to litigating any future patent dispute, the parties will engage in good faith negotiations and will consider arbitrating the dispute before resorting to litigation. The Company believes that the royalty rates being charged by P&G, together with royalties to be paid to K-C described below, will have a material adverse impact on the Company's future financial condition and results of operations. Under the terms of the P&G Settlement Agreement, the Company and P&G jointly requested modification of the injunction entered in Delaware District Court so as to allow the Company to begin converting to a dual cuff design pursuant to the License Agreements described above. The injunction was modified as requested on February 22, 1999 and the product conversion is complete. As also provided under the terms of the P&G Settlement Agreement, once a Final Order, as defined therein, has been entered by the Bankruptcy Court approving the settlement, the Company will withdraw with prejudice its appeal of the Delaware Judgment to the Federal Circuit, and P&G will withdraw with prejudice its motion in Delaware District Court to find the Company in contempt of the Delaware Judgment. A hearing on the Company's motion to seek approval from the Bankruptcy Court of this settlement was commenced on March 22 and 23, 1999 and resumed on April 13, 14 and 15, 1999. Closing arguments have been scheduled for June 8, 1999. Both the Equity Committee and K-C have objected to the P&G settlement. The Company intends to continue to pursue approval of the P&G Settlement by the Bankruptcy Court. Should the P&G Settlement Agreement not be approved by a Final Order of the Bankruptcy Court by July 31, 1999, however, the License Agreements described above will become terminable at P&G's option. The Company cannot predict when, or if, such approval will be granted. K-C filed alleged claims ranging from approximately $893,000 (without trebling) to $2,300,000 (with trebling), including claims related to the litigation in the Dallas District Court described above. See "--Kimberly-Clark Corporation v. Paragon Trade Brands, Inc.," above. K-C's claims in the Bankruptcy case include an attempt to recover alleged lost profits for infringement of the patents asserted in the Dallas District Court, despite the fact that a lost profits theory of damages was not pursued by K-C in the Dallas District Court. -16- 17 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) On March 19, 1999, the Company entered into a Settlement Agreement with K-C which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Texas action, including the Company's counterclaims, and K-C's proof of claim filed in the Company's Chapter 11 reorganization proceeding. Under the terms of the K-C Settlement Agreement, the Company grants K-C an allowed unsecured prepetition claim of $110,000 and an allowed administrative claim of $5,000. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to the patents asserted in the Texas action. The patent rights licensed by the Company from K-C will allow the Company to manufacture a dual cuff diaper design. In exchange for these patent rights, the Company has agreed to pay K-C annual running royalties on net sales of the licensed products in the U.S. and Canada equal to: 2.5 percent of the first $200,000 of net sales of the covered diaper products and 1.5 percent of such net sales in excess of $200,000 in each calendar year commencing January 1999 through November 2004. The Company has agreed to pay a minimum annual royalty for diaper sales of $5,000, but amounts due on the running royalties will be offset against this minimum. The Company will also pay K-C running royalties of 5 percent of net sales of covered training pant products for the same period, but there is no minimum royalty for training pants. As part of the settlement, the Company has granted a royalty-free license to K-C for three patents which the Company in the Texas action claimed K-C infringed. The Company believes that the overall effective royalty rates that the Company will pay to K-C will, together with royalties to be paid to P&G described above, have a material adverse impact on the Company's future financial condition and results of operations. As a part of the K-C License Agreement, K-C has agreed not to sue the Company on two of K-C's patents related to the use of SAP in diapers and training pants, so long as the Company remains within the SAP Safe Harbor. The Company has experienced certain product performance issues the Company believes may be related to such SAP. As a result, the Company expects that it will incur increased marketing and SG&A expenditures in 1999 to address product performance issues. These increased expenditures are expected to have a material adverse impact on the Company's financial position and results of operations in 1999. The Company is encountering increased product costs due to the increased price and usage of the new SAP. While the Company is working diligently with its SAP suppliers to develop a better performing alternative which is still within the SAP Safe Harbor, the Company cannot predict at this time whether or when such an alternative SAP would be available. The Company expects that these increased product costs will have a material adverse impact on its financial condition and results of operations for at least 1999 and potentially beyond. Upon the Effective Date, as defined in the K-C Settlement Agreement, K-C will dismiss with prejudice its complaint in the Texas action, as well as its related filings in the District Court in Georgia, and the Company will simultaneously dismiss with prejudice its counterclaims in the Texas action. The Company has filed a motion with the Bankruptcy Court to seek approval of the settlement and a hearing date has been set for June 9, 10 and 11, 1999. If the K-C Settlement Agreement is not approved by an order of the Bankruptcy Court entered before August 1, 1999, the K-C License Agreement described above will terminate automatically. The Company intends to vigorously pursue approval of the settlement but cannot predict when, or if, such approval will be granted. By Order of the Bankruptcy Court on April 19, 1999, the Company's exclusivity period, during which time only the Company can propose a plan of reorganization, was extended initially to May 19, 1999. Should no interested party object by May 12, 1999, the Company's exclusivity period will automatically extend to June 19, 1999. If a timely objection is filed, a hearing is scheduled for May 17, 1999. On January 30, 1998, the Company received Bankruptcy Court approval of a $75,000 financing facility with a bank group led by The Chase Manhattan Bank. This facility is designed to supplement the Company's cash on hand and operating cash flow and to permit the Company to continue to operate its business in the ordinary course. As of March 28, 1999, there were no outstanding direct borrowings under this facility. The Company had an aggregate of $3,604 in letters of credit issued under the DIP Credit Facility at March 28, 1999. The DIP Credit Facility contains customary covenants. The Company for a period of time had been unable to fully comply with -17- 18 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) certain reporting requirements of such covenants. The Company obtained waivers with respect to these events of default which were effective through May 10, 1999. The Company believes that it is in compliance with the reporting requirements of the DIP Credit Facility. See Note 12. Legal fees and costs in connection with the Chapter 11 case have been and will continue to be significant. The Company is unable to predict at this time when it will emerge from Chapter 11 protection. Tracy Patent - The Company had previously received notice from a Ms. Rhonda Tracy that Ms. Tracy believes the Company's diapers infringe a patent issued in August 1998 to Ms. Tracy (U.S. Patent No. 5,797,824). The Company responded, based upon advice of its independent patent counsel, that it believes its products do not infringe any valid claim of Ms. Tracy's patent. On April 29, 1999, the Company received notice that Ms. Tracy had filed suit in the United States District Court for the Northern District of Illinois against K-C, Tyco International, Ltd., Drypers Corporation and a number of the Company's customers, alleging infringement of her patent. The Company was not named as a defendant in this suit. Rather, Ms. Tracy indicated in her April 29, 1999 letter that the Company would be sued upon completion of the current suit. The Company is currently evaluating its options regarding this lawsuit, including, among other things, seeking to intervene in the suit. Other -- The Company is also a party to other legal activities generally incidental to its activities. Although the final outcome of any legal proceeding or dispute is subject to a great many variables and cannot be predicted with any degree of certainty, the Company presently believes that any ultimate liability resulting from any or all legal proceedings or disputes to which it is a party, except for the Chapter 11 filing and the P&G and K-C matters discussed above, will not have a material adverse effect on its financial condition or results of operations. NOTE 12: BANK CREDIT FACILITIES On January 30, 1998, the Bankruptcy Court entered a final order (the "Final Order") approving the Credit Agreement (the "DIP Credit Facility") as provided under the Revolving Credit and Guaranty Agreement dated as of January 7, 1998, among the Company, as borrower, certain subsidiaries of the Company as guarantors, and The Chase Manhattan Bank, as agent ("Chase"). Pursuant to the terms of the DIP Credit Facility, as amended by the First Amendment dated January 30, 1998, the Second Amendment dated March 23, 1998, the Third Amendment dated April 15, 1998 and the Fourth Amendment dated September 28, 1998, Chase and a syndicate of banks have made available to the Company a revolving credit and letter of credit facility in an aggregate principal amount of $75,000. The Company's maximum borrowing under the DIP Credit Facility may not exceed the lesser of $75,000 or an available amount as determined by a borrowing base formula. The borrowing base formula is comprised of certain specified percentages of eligible accounts receivable, eligible inventory, equipment and personal and real property of the Company. The DIP Credit Facility has a sublimit of $10,000 for the issuance of letters of credit. The DIP Credit Facility expires on the earlier of July 7, 1999, or the date of entry of an order by the Bankruptcy Court confirming a plan of reorganization. The Company is currently negotiating an extension of the maturity date on the DIP Credit Facility with Chase. Obligations under the DIP Credit Facility are secured by the security interest in, pledge and lien on substantially all of the Company's assets and properties and the proceeds thereof, granted pursuant to the Final Order under Sections 364(c)(2) and 364(c)(3) of the Bankruptcy Code. Borrowings under the DIP Credit Facility may be used to fund working capital and for other general corporate purposes. The DIP Credit Facility contains restrictive covenants, including among other things, limitations on the creation of additional liens and indebtedness, limitations on capital expenditures, limitations on transactions with affiliates including investments, loans and advances, the sale of assets, and the maintenance of minimum earnings before interest, taxes, depreciation, amortization and reorganization items, as well as a prohibition on the payment of dividends. The DIP Credit Facility provides that advances made will bear interest at a rate of 0.5 percent per annum in excess of Chase's Alternative Base Rate, or at the Company's option, a rate of 1.5 percent per annum in excess of the reserve adjusted London Interbank Offered Rate for the interest periods of one, two or three months. The Company pays a commitment fee of 0.5 percent per annum on the unused portion thereof, a letter of credit fee equal to 1.5 percent per annum of average outstanding letters of credit and certain other fees. -18- 19 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) At March 28, 1999, there were no outstanding direct borrowings under the DIP Credit Facility. The Company had an aggregate of $3,604 in letters of credit issued under the DIP Credit Facility at March 28, 1999. The DIP Credit Facility contains customary covenants. The Company for a period of time had been unable to fully comply with certain reporting requirements of such covenants. The Company obtained waivers with respect to these events of default which were effective through May 10, 1999. The Company believes that it is in compliance with the reporting requirements of the DIP Credit Facility. At December 28, 1997, the Company maintained a $150,000 revolving credit facility with a group of nine financial institutions available through February 2001. At December 28, 1997, borrowings under this credit facility totaled $70,000. Interest was at fixed or floating rates based on the financial institution's cost of funds. Paragon Trade Brands (Canada) Inc. ("PTB Canada") has guaranteed obligations under this revolving credit facility. The Company also had access to short-term lines of credit on an uncommitted basis with several major banks. At December 28, 1997, the Company had approximately $50,000 in uncommitted lines of credit. Borrowings under these lines of credit totaled $12,800 at December 28, 1997. As a result of the Chapter 11 filing, the Company is prohibited from paying any prepetition liabilities without Bankruptcy Court approval. The Chapter 11 filing resulted in a default under the Company's prepetition revolving credit facility and its borrowings under uncommitted lines of credit. The terms of the revolving credit facility and the short-term lines of credit above provide that a voluntary filing of a Chapter 11 petition results in an event of default on such indebtedness. Amounts outstanding under these facilities are reflected as Liabilities Subject to Compromise in the accompanying consolidated balance sheet as of December 27, 1998. As a result of its Chapter 11 filing, the Company is prohibited from paying any prepetition liabilities without Bankruptcy Court approval. Accordingly, no interest expense has been recorded with respect to prepetition debt balances in the accompanying financial statements for the period subsequent to January 6, 1998. PTB Canada entered into a new $3,000 Cdn operating credit facility with a financial institution dated February 11, 1998. Borrowings under the prior Canadian revolving credit facility were repaid in full with the proceeds from borrowings under the new Canadian operating credit facility. Borrowings under this Canadian operating credit facility are secured by substantially all of PTB Canada's assets and will bear interest at a rate of 1 percent over the financial institution's prime rate. The Company does not guaranty borrowings under the Canadian operating credit facility. The maximum borrowings under the Canadian operating credit facility are limited to the lesser of $3,000 Cdn or 75 percent of PTB Canada's trade accounts receivable. There were no borrowings outstanding under this operating credit facility on March 28, 1999. See Note 14. NOTE 13: SEGMENT REPORTING The Company operates principally in two segments that are organized based on the nature of the products sold: (i) infant care and (ii) feminine care and adult incontinence. Each operating segment contains closely related products that are unique to that particular segment. The results of Changing Paradigms, Inc., which was sold in October of 1998, and the Company's international investment in joint ventures in Mexico, Argentina, Brazil and China are reported in the corporate and other segment. Management evaluates the performance of its operating segments separately to individually monitor the different factors impacting financial performance. Segment operating profit is comprised of net sales less cost of sales and selling, general and administrative expense. Loss contingencies and asset impairments are recorded in the appropriate operating segment. -19- 20 PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION) NOTES TO FINANCIAL STATEMENTS - (CONTINUED) Certain administrative expenses common to all operating segments are currently allocated to the infant care operating segment. International investments, financial costs, such as interest income and expense, and income taxes are managed by, and recorded in, the corporate and other operating segment.
Feminine Care/Adult Corporate/ Period Ending March 28, 1999 Infant Care Incontinence Other Total ----------- ------------ ----------- --------- Net sales $ 123,356 $ 2,888 $ -- $ 126,244 Operating profit (loss) (2,470) (3,274) -- (5,744) Feminine Care/Adult Corporate/ Period Ending March 29, 1998 Infant Care Incontinence Other Total ----------- ------------ ----------- --------- Net sales $ 131,915 $ 1,487 $ 4,895 $ 138,297 Operating profit (loss) 10,030 (3,332) 347 7,044
NOTE 14: SUBSEQUENT EVENT On April 30, 1999, the Company announced that its Canadian subsidiary, PTB Canada, would cease manufacturing infant disposable diapers at its Brampton, Ontario facility. The Company anticipates recording a charge to earnings in the second quarter of 1999 in connection with costs related to this action. The Brampton plant employed approximately 113 people. The Company announced that the facility would curtail manufacturing operations over a few weeks' period of time while the Company transitions its Canadian customers to its Harmony, Pennsylvania facility. Thereafter, the Company expects that the Brampton facility will operate as a warehouse and distribution facility. -20- 21 PART I. FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION PARAGON TRADE BRANDS, INC. AND SUBSIDIARIES THIRTEEN WEEKS ENDED MARCH 28, 1999 COMPARED TO THIRTEEN WEEKS ENDED MARCH 29, 1998 CHAPTER 11 PROCEEDINGS The Company has previously disclosed that The Procter & Gamble Company ("P&G") had filed a lawsuit against it in the United States District Court for the District of Delaware alleging that the Company's "Ultra" disposable baby diaper products infringed two of P&G's dual cuff diaper patents. The lawsuit sought injunctive relief, lost profit and royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by P&G. The Company also disclosed that if P&G were to prevail on its claims, an award of all or a substantial amount of the relief requested by P&G could have a material adverse effect on the Company's financial condition and results of operations. On December 30, 1997, the District Court issued a Judgment and Opinion which found, in essence, two of P&G's dual cuff diaper patents to be valid and infringed by certain of the Company's disposable diaper products, while also rejecting the Company's patent infringement claims against P&G. The District Court had earlier dismissed the Company's antitrust counterclaim on summary judgment. The Judgment entitled P&G to damages based on sales of the Company's diapers containing the "inner-leg gather" feature. While the final damages number of approximately $178.4 million was not entered by the District Court until June 2, 1998, the Company originally estimated the liability and associated litigation costs to be approximately $200 million. The amount of the award resulted in violation of certain covenants under the Company's then-existing bank loan agreements. As a result, the issuance of the Judgment and the uncertainty it created caused an immediate and critical liquidity issue for the Company. On January 6, 1998, the Judgment was entered on the docket in Delaware in such a manner that P&G would have been able to begin placing liens on the Company's assets. As a result, the Company filed for relief under Chapter 11 of the Bankruptcy Code, 11 U.S.C. Section 101 et seq., in the United States Bankruptcy Court for the Northern District of Georgia (Case No. 98-60390) on January 6, 1998 (the "Chapter 11 filing"). None of the Company's subsidiaries were included in the Chapter 11 filing. The Chapter 11 filing was designed to prevent P&G from placing liens on Company property, permit the Company to appeal the Delaware District Court's decision on the P&G case in an orderly fashion and give the Company the opportunity to resolve liquidated and unliquidated claims against the Company, which arose prior to the Chapter 11 filing. The Company is currently operating as a debtor-in-possession under the Bankruptcy Code. On February 2, 1999, the Company entered into a Settlement Agreement with P&G which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Delaware Judgment, the Company's appeal of the Delaware Judgment, P&G's motion to find the Company in contempt of the Delaware Judgment and P&G's proof of claim filed in the Company's Chapter 11 reorganization proceeding. As a part of the P&G settlement, Paragon grants P&G an allowed unsecured prepetition claim of $158.5 million and an allowed administrative claim of $5 million. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to certain of the patents asserted by P&G in its proof of claim, including those asserted in the Delaware Action. The U.S. and Canadian patent rights licensed by the Company will allow the Company to manufacture a dual cuff baby diaper design. In exchange for these rights, the Company has agreed to pay P&G running royalties on net sales of the licensed products equal to 2 percent through October 2005, .75 percent thereafter through October 2006 and .375 percent thereafter through March 2007 in the U.S.; and 2 percent through October 2008 and 1.25 percent thereafter through December 2009 in Canada. The Settlement Agreement also provides, among other things, that P&G will grant the Company and/or its affiliates "most favored licensee" status with respect to patents owned by P&G on the date of the Settlement Agreement or for which an application was pending on that date. In addition, the Company has agreed with P&G that prior to litigating any future patent dispute, the parties will engage in good faith negotiations and will consider arbitrating the dispute before resorting to litigation. -21- 22 While the Company believes that the royalty rates being charged by P&G are the same royalties that will be paid by the Company's major store brand competitors for similar patent rights, these royalties, together with royalties to be paid to Kimberly-Clark Corporation ("K-C") described below, will have a material adverse impact on the Company's future financial condition and results of operations. While these royalty costs are expected to be partially offset by projected raw material cost savings related to the conversion to a dual cuff design, the Company's overall raw material costs are expected to increase. These royalty costs are also expected to be partially offset by price increases announced by the Company in the fourth quarter of 1998 to the extent such price increases are realized. Under the terms of the P&G Settlement Agreement, the Company and P&G jointly requested modification of the injunction entered in Delaware District Court so as to allow the Company to begin converting to a dual cuff design pursuant to the License Agreements described above. The injunction was modified as requested on February 22, 1999 and the product conversion is complete. As also provided under the terms of the P&G Settlement Agreement, once a Final Order, as defined therein, has been entered by the Bankruptcy Court approving the settlement, the Company will withdraw with prejudice its appeal of the Delaware Judgment to the Federal Circuit, and P&G will withdraw with prejudice its motion in Delaware District Court to find the Company in contempt of the Delaware Judgment. A hearing on the Company's motion to seek approval from the Bankruptcy Court of this settlement was commenced on March 22 and 23, 1999 and resumed on April 13, 14 and 15, 1999. Closing arguments have been scheduled for June 8, 1999. Both the Official Committee of Equity Holders (the "Equity Committee") and K-C have objected to the P&G settlement. The Company intends to continue to pursue approval of the P&G Settlement by the Bankruptcy Court. Should the P&G Settlement Agreement not be approved by a Final Order of the Bankruptcy Court by July 31, 1999, however, the License Agreements described above will become terminable at P&G's option. The Company cannot predict when, or if, such approval will be granted. See "--Risks and Uncertainties" below, and "PART II: OTHER INFORMATION, ITEM 1: LEGAL PROCEEDINGS." On October 26, 1995, K-C filed a lawsuit against the Company in U.S. District Court in Dallas, Texas, alleging infringement by the Company's products of two K-C patents relating to dual cuffs. The lawsuit sought injunctive relief, royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by K-C. In addition, K-C sued the Company on another patent issued to K-C which is based upon a further continuation of one of the K-C dual cuff patents asserted in the case. On March 19, 1999, the Company entered into a Settlement Agreement with K-C which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Texas action, including the Company's counterclaims, and K-C's proof of claim filed in the Company's Chapter 11 reorganization proceeding. Under the terms of the K-C Settlement Agreement, the Company grants K-C an allowed unsecured prepetition claim of $110 million and an allowed administrative claim of $5 million. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to the patents asserted by K-C in the Texas action. The patent rights licensed by the Company from K-C will allow the Company to manufacture a dual cuff diaper design. In exchange for these patent rights, the Company has agreed to pay K-C annual running royalties on net sales of the licensed products in the U.S. and Canada equal to: 2.5 percent of the first $200 million of net sales of the covered diaper products and 1.5 percent of such net sales in excess of $200 million in each calendar year commencing January 1999 through November 2004. The Company has agreed to pay a minimum annual royalty for diaper sales of $5 million, but amounts due on the running royalties will be offset against this minimum. The Company will also pay K-C running royalties of 5 percent of net sales of covered training pant products for the same period, but there is no minimum royalty for training pants. As part of the settlement, the Company has granted a royalty-free license to K-C for three patents which the Company in the Texas action claimed K-C infringed. While the Company believes that, based on its projected level of sales, the overall effective royalty rate that the Company will pay to K-C is less than the royalty rate that will be paid by the Company's major store brand competitors for similar patent rights, these royalties will, together with royalties to be paid to P&G described above, have a material adverse impact on the Company's future financial condition and results of operations. While these royalty costs are expected to be partially offset by projected raw material cost savings related to the conversion to a dual cuff product, the Company's overall raw material costs are expected to increase. These royalty costs are also expected to be partially offset by price increases announced by the Company in the fourth quarter of 1998 to the extent such price increases are realized. -22- 23 As a part of the K-C License Agreement, K-C has agreed not to sue the Company on two of K-C's patents related to the use of SAP in diapers and training pants, so long as the Company remains within the SAP Safe Harbor. The Company has experienced certain product performance issues the Company believes may be related to such SAP. As a result, the Company expects that it will incur increased marketing and selling, general and administrative expenses ("SG&A") expenditures in 1999 to address product performance issues. These increased expenditures are expected to have a material adverse impact on the Company's financial position and results of operations in 1999. The Company is encountering increased product costs due to the increased price and usage of the new SAP. While the Company is working diligently with its SAP supplier to develop a better performing alternative which is still within the SAP Safe Harbor, the Company cannot predict at this time whether or when such an alternative SAP would be available. The Company expects that these increased product costs will have a material adverse impact on its financial condition and results of operations for at least 1999 and potentially beyond. Upon the Effective Date, as defined in the K-C Settlement Agreement, K-C will dismiss with prejudice its complaint in the Texas action, as well as its related filings in the District Court in Georgia, and the Company will simultaneously dismiss with prejudice its counterclaims in the Texas action. The Company has filed a motion with the Bankruptcy Court to seek approval of the settlement and a hearing date has been set for June 9, 10 and 11, 1999. If the K-C Settlement Agreement is not approved by an order of the Bankruptcy Court entered before August 1, 1999, the K-C License Agreement described above will terminate automatically. The Company intends to vigorously pursue approval of the settlement but cannot predict when, or if, such approval will be granted. See "--Risks and Uncertainties." The Company is unable to predict at this time when it will emerge from Chapter 11 protection. See "Notes 1 and 11 of Notes to Financial Statements" and "PART II: OTHER INFORMATION, ITEM 1: LEGAL PROCEEDINGS" herein. The Company operates principally in two segments that are organized based on the nature of the products sold: (i) infant care and (ii) feminine care and adult incontinence. Each operating segment contains closely related products that are unique to that particular segment. The results of Changing Paradigms, Inc. ("Changing Paradigms"), the Company's household cleaners and air freshener business that was sold in 1998, and the Company's international investments in joint ventures in Mexico, Argentina, Brazil and China are reported in the corporate and other segment. RESULTS OF OPERATIONS Net loss was $7.2 million in the first quarter of 1999 compared to net earnings of $6.0 million in the first quarter of 1998. Reduced volume, higher royalties and product costs, manufacturing inefficiencies due to the lower volume, product design-related machine changeovers, and increased SG&A expenditures all contributed to the loss in the first quarter of 1999. The first quarter of 1999 results were also negatively impacted by a price concession made to an export customer to address product acceptance issues. Included in the first quarter 1999 results are bankruptcy costs of $1.9 million compared to $1.6 million in the first quarter of 1998. Basic loss per share in the first quarter of 1999 was $.60 compared to basic earnings per share of $.50 in the first quarter of 1998. Excluding the effects of contractual interest and bankruptcy costs, net of tax, and the tax valuation allowance matters discussed below, basic loss per share was $.32 in the first quarter of 1999 compared to basic earnings of $.35 per share in the first quarter of 1998. Infant care operating losses were $2.5 million in the first quarter of 1999 compared to an operating profit of $10.0 million in the first quarter of 1998. Lower unit volume, increased product royalties and material costs, the concession discussed above and manufacturing inefficiencies due to lower volume and machine changeovers all contributed to the infant care operating loss. Feminine care and adult incontinence operating losses were $3.3 million in the first quarters of 1999 and 1998. Losses are expected to continue until volume is significantly increased to absorb existing manufacturing capacity. The Company experienced greater than anticipated operating losses in its feminine care and adult incontinence businesses in 1998 and 1997. While the Company expects these losses to continue near-term, the Company has developed a business plan that supports the realization of its investment in its feminine care and adult incontinence business. Accordingly, the Company has not recorded any adjustments in its financial statements -23- 24 relating to the recoverability of the operating assets of the feminine care and adult incontinence business The Company's ability to recover its investment is dependent upon a prompt emergence from Chapter 11 and the successful execution of the Company's feminine care and adult incontinence business plan. The Company cannot predict at this time when it will emerge from Chapter 11 protection. The Company believes that once it emerges from Chapter 11, the feminine care and adult incontinence business will see an increase in sales and improved results. The Company cannot predict, however, whether or when such improved results will be realized. See "Risks and Uncertainties" herein. NET SALES Overall net sales were $126.2 million in the first quarter of 1999 compared to $138.3 million in the first quarter of 1998. Infant care net sales decreased 6.3 percent to $123.4 compared to $131.9 in the first quarter of 1998. Unit sales decreased 6.6 percent to 826.7 million units compared to 885.4 million units in the first quarter of 1998. The decrease in sales was due to a number of reasons, including certain product performance issues primarily related to the SAP used in diapers and training pants manufactured in late 1998 and early 1999, the discontinuation of shipments to a major customer since mid-1998 due to product design issues, continued competitive pressures and the uncertainties related to the Company's Chapter 11 proceedings. In addition, a price concession was made to an export customer during the first quarter of 1999 to address product acceptance issues. The Company believes that the product performance issues are being addressed as a result of the conversion to a dual cuff diaper and the introduction of an improved SAP in the first quarter of 1999, both of which have been completed, and other product changes planned for the second quarter of 1999. The Company also believes that shipments to the major customer that had been suspended in 1998 will reach normal levels during the second half of 1999. Volume remained under pressure during the quarter from discounts and promotional allowances by branded manufacturers and value segment competitors. Infant care volume and sales prices are expected to remain under pressure due to product performance and design issues, until remedied, continued competitive initiatives from both national brand and store brand competitors and a prolonged Chapter 11 case. However, the continuing roll-out of an improved Ultra diaper which incorporates stretch tabs and a hook and loop closure system, and the introduction of a new training pant product are expected to increase volume during the second half of 1999. The Company began to implement a price increase of approximately 5 percent during the fourth quarter of 1998 in response to price increases announced by K-C and P&G. As a result, excluding the effect of a price concession made to an export customer in the first quarter of 1999 described above, average sales prices during the first quarter of 1999 were higher compared to the first quarter of 1998. It is difficult to predict the amount of the final realization of this price increase due to competitive factors previously discussed and the Company's continuing Chapter 11 case. See "Risks and Uncertainties" herein. Feminine care and adult incontinence sales nearly doubled to $2.9 million in the first quarter of 1999 compared to $1.5 million in the first quarter of 1998 due to the shipment of product to new customers. However, the uncertainty caused by the Company's chapter 11 filing has significantly impacted the ability to attract additional sales. The Company expects this condition to persist until the Company's emergence from Chapter 11. See "Risks and Uncertainties" herein. Corporate and other net sales of $4.9 million in the first quarter of 1998 relate to Changing Paradigms which was sold in October of 1998. COST OF SALES Overall cost of sales in the first quarter of 1999 was $109.5 million compared to $110.8 million in the first quarter of 1998. As a percentage of net sales, cost of sales was 86.8 percent in the first quarter of 1999 compared to 80.1 percent in the first quarter of 1998. Infant care costs were $103.5 million in the first quarter of 1999 compared to $102.3 million in the first quarter of 1998. As a percentage of net sales, infant care cost of sales was 83.7 percent in the first quarter of 1999 compared to 77.5 percent in 1998. This increase in costs as a percentage of sales was due to manufacturing inefficiencies due to lower volume, increased raw material costs associated with the single cuff product and higher product royalties as a result of the settlement and licensing agreements reached in the first quarter of 1999 -24- 25 with P&G and K-C. Product costs are expected to increase significantly in 1999 due to the payment of royalties to P&G and K-C, increased price and usage of the new SAP and increased product and manufacturing costs associated with the continuing roll-out of the improved Ultra diaper described above. These increased costs are expected to be partially offset by manufacturing efficiencies resulting from volume increases anticipated in the second half of 1999 and management cost reduction initiatives. Infant care raw material prices, primarily pulp, were at lower price levels in the first quarter of 1999 compared to the first quarter of 1998. SAP costs, however, increased during the first quarter of 1999 compared to the first quarter of 1998. Raw material prices, primarily pulp, are expected to increase in 1999. Infant care depreciation costs were $5.8 million in the first quarter of 1999 compared to $6.6 million in first quarter of 1998. Feminine care and adult incontinence cost of sales was $6.0 million in the first quarter of 1999 compared to $4.3 million in the first quarter of 1998. As a percentage of net sales, cost of sales was 206.9 percent in the first quarter of 1999 compared to 286.7 percent in the first quarter of 1998. Overall cost of sales is expected to remain greater than net sales until volume is significantly increased to absorb existing manufacturing capacity. See "Risks and Uncertainties" herein. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES SG&A expenses were $21.4 million in the first quarter of 1999 compared to $19.1 million in the first quarter of 1998. As a percentage of net sales, these expenses were 17.0 percent in the first quarter of 1999 compared to 13.8 percent in 1998. The increase in SG&A is primarily attributable to an increase in promotional spending, information technology and sales and marketing expenditures. Depreciation and amortization costs included in SG&A increased to $1.6 million in the first quarter of 1999 compared to $.8 million in the first quarter of 1998. This increase resulted from the amortization of software and consulting costs associated with the implementation of an enterprise resource planning system in the fourth quarter of 1998. Overall, SG&A expenses are expected to remain at similar levels throughout 1999. RESEARCH AND DEVELOPMENT Research and development expenses were $1.0 million in the first quarter of 1999 compared to $1.4 million in the first quarter of 1998. INTEREST EXPENSE Interest expense was $.1 million in the first quarter of 1999 compared to $.3 million in the first quarter of 1998. There were no borrowings under the DIP credit facility during the first quarter of 1999 or 1998. EQUITY IN EARNINGS OF UNCONSOLIDATED SUBSIDIARIES The equity in earnings of unconsolidated subsidiaries was $.4 million in the first quarter of 1999 compared to $.9 million in the first quarter of 1998. The decrease in earnings reflects the write-off of capitalized start-up costs and losses associated with the Company's China joint venture. BANKRUPTCY COSTS Bankruptcy costs were $1.9 million in the first quarter of 1999 compared to $1.6 million during the first quarter of 1998. These costs were primarily related to professional fees and are expected to continue at similar to higher levels until the Company emerges from Chapter 11. INCOME TAXES Income tax expense for the subsidiaries not included in the Chapter 11 filing was $.3 and $.5 million during the periods ended March 28, 1999 and March 29, 1998, respectively. The Company recorded an income tax benefit of approximately $3.0 million during the period ended March 28, 1999, which was offset by an increase in the valuation allowances with respect to its net deferred and other tax-related assets as realization is dependent upon -25- 26 sufficient taxable income in the future. The Company recorded income tax expense of approximately $1.8 million during the period ended March 29, 1998, which was offset by a reduction in the valuation allowances. LIQUIDITY AND CAPITAL RESOURCES During the first quarter of 1999, cash flow from earnings (losses) and non-cash charges was $.8 million compared to $13.9 million in the first quarter of 1998. During the first quarter of 1999, cash flow was positively impacted by a $17.0 million reduction in accounts receivable which offset the impact of operating losses, reductions in checks issued but not cleared and accrued liabilities due to the payment of 1998 incentive based compensation. In the fourth quarter of 1998, receivables increased significantly due primarily to an electronic billing issue related to a few large customers. This issue was corrected and receivables returned to more normal levels in the first quarter of 1999. Cash flow was also positively impacted by $5.2 million of asset sales and the receipt of proceeds from equipment sales in previous quarters. The cash produced from operations supported capital expenditures of $11.7 million, including approximately $.7 million of computer software and consulting costs, for the first quarter of 1999 compared to $5.4 million, including $2.0 million of computer software and consulting costs in the same period of 1998. The expenditures in the first quarter of 1999 were primarily related to the addition of increased training pant capacity and new product enhancements. Capital spending is expected to be approximately $46.0 million during 1999 which the Company expects will be funded through a combination of internally generated funds and borrowings under the DIP Credit Facility. In connection with the Chapter 11 filing, on January 30, 1998, the Bankruptcy Court entered a Final Order approving the DIP Credit Facility as provided under the Revolving Credit and Guarantee Agreement dated as of January 7, 1998, among the Company, as Borrower, certain subsidiaries of the Company, as guarantors, and a bank group led by The Chase Manhattan Bank ("Chase"). Pursuant to the terms of the DIP Credit Facility, as amended by the First Amendment dated January 30, 1998, the Second Amendment dated March 23, 1998, the Third Amendment dated April 15, 1998 and the Fourth Amendment dated September 28, 1998, Chase and a syndicate of banks has made available to the Company a revolving credit and letter of credit facility in an aggregate principal amount of $75 million. The Company's maximum borrowing under the DIP Credit Facility may not exceed the lesser of $75 million or an available amount as determined by a borrowing base formula. The borrowing base formula is comprised of certain specified percentages of eligible accounts receivable, eligible inventory, equipment and personal and real property of the Company. The DIP Credit Facility has a sublimit of $10 million for the issuance of letters of credit. The DIP Credit Facility expires on the earlier of July 7, 1999, or the date of entry of an order by the Bankruptcy Court confirming a plan of reorganization. The Company is currently negotiating an extension of the maturity date of the DIP Credit Facility. Obligations under the DIP Credit Facility are secured by the security interest, pledge and lien on substantially all of the Company's assets and properties and the proceeds thereof, granted pursuant to the Final Order under Sections 364(c)(2) and 364(c)(3) of the Bankruptcy Code. Borrowings under the DIP Credit Facility may be used to fund working capital and for other general corporate purposes. The DIP Credit Facility contains restrictive covenants, including among other things, limitations on the creation of additional liens and indebtedness, limitations on capital expenditures, limitations on transactions with affiliates including investments, loans and advances, the sale of assets, and the maintenance of minimum earnings before interest, taxes, depreciation, amortization and reorganization items, as well as a prohibition on the payment of dividends. The DIP Credit Facility provides that advances made will bear interest at a rate of 0.5 percent per annum in excess of Chase's Alternative Base Rate, or at the Company's option, a rate of 1.5 percent per annum in excess of the reserve adjusted London Interbank Offered Rate for the interest periods of one, two or three months. The Company pays a commitment fee of 0.5 percent per annum on the unused portion thereof, a letter of credit fee equal to 1.5 percent per annum of average outstanding letters of credit and certain other fees. The Company may utilize, in accordance with certain covenants, its DIP Credit Facility for continued investments in its foreign subsidiaries. The DIP Credit Facility, in combination with internally-generated funds, is anticipated to be adequate to finance these investments and the Company's 1999 capital expenditures. At March 28, 1999, there were no outstanding direct borrowings under the DIP Credit Facility. The Company had an aggregate of $3.6 million in letters of credit issued under the DIP Credit Facility at March 28, 1999. The DIP Credit Facility contains customary covenants. The Company for a period of time had been unable to fully comply with certain reporting requirements of such covenants. The Company obtained waivers with respect to these -26- 27 events of default which were effective through May 10, 1999. The Company believes that it is in compliance with the reporting requirements of the DIP Credit Facility. See "Note 12 of Notes to Financial Statements." At December 28, 1997, the Company maintained a $150 million revolving credit facility with a group of nine financial institutions available through February 2001. At December 28, 1997, borrowings under this credit facility totaled $70 million. The Company also had access to short-term lines of credit on an uncommitted basis with several major banks. At December 28, 1997, the Company had approximately $50 million in uncommitted lines of credit. Borrowings under these lines of credit totaled $12.8 million at December 28, 1997. As a result of the Chapter 11 filing, the Company is prohibited from paying any prepetition liabilities without Bankruptcy Court approval. The Chapter 11 filing resulted in a default under the Company's prepetition revolving credit facility and its borrowings under uncommitted lines of credit. See "Note 12 of Notes to Financial Statements." YEAR 2000 The "Year 2000 issue" is generally defined as the inability of computer hardware, software and embedded systems to properly recognize and process date-related information for dates after December 31, 1999. The Company began its efforts to address this problem as early as 1995. The Company's efforts generally are separated into three areas: (i) business information systems ("Business Systems"), (ii) non-information technology systems, including real estate facilities and manufacturing equipment ("Infrastructure Systems"), and (iii) vendors, suppliers, customers and third party information interfaces ("Third Party Dependencies"). The Company has established a formal "Y2K Project Office" to assess, manage and implement its Year 2000 activities. The Company has also established a formal "Y2K Steering Committee" to oversee the Company's Year 2000 efforts, including the efforts of the Project Office. The Company has also engaged Deloitte Consulting/ICS to assist with implementation of certain Year 2000 related Business Systems and the GartnerGroup to assist with its Year 2000 efforts for Infrastructure Systems and Third Party Dependencies. The Company's State of Readiness Most of the Year 2000 issues arising with respect to the Business Systems of the Company have been addressed by replacement of the majority of those systems with SAP R/3 enterprise resource planning software. The SAP software was implemented and operating at the Company's corporate headquarters and in its U.S. infant care plants in early November of 1998 and is warranted to be Year 2000 compliant by its manufacturer. The SAP implementation should help significantly minimize any Year 2000 related disruptions for approximately 80 percent of the Company's Business Systems at those locations. The Company estimates that the SAP implementation and its other Year 2000 efforts thus far have addressed 80 percent of the critical Year 2000 exposures related to its Business Systems as a whole. The remaining systems are being addressed and are expected to be fully assessed, remediated or replaced, tested and implemented prior to the fourth quarter of 1999. With respect to Business Systems that will not be addressed by the overall SAP implementation, the Company is currently addressing certain issues with certain of its desktop computer operating systems. Approximately half of the desktop computers used by the Company have currently been addressed and the Company expects to complete the remaining half by the end of the second quarter of 1999. Overall, the Company currently anticipates completion of remediation and testing of all of its critical Business Systems by the end of the third quarter of 1999. The Company has engaged the GartnerGroup to evaluate and analyze the Company's overall Year 2000 preparedness. The Company has received formal reports from the GartnerGroup and has initiated remediation/replacement procedures for certain processes and systems identified in such reports. The Company has also internally evaluated certain of its Infrastructure Systems for Year 2000 related problems. These systems include the manufacturing capacity for the Company's products and are therefore critical to the Company's ability to produce products and realize revenue from sales. The manufacturing capacity of the Company includes any number of automated systems which may include embedded chips that are difficult to identify and remediate in the event of Year 2000 related problems. While difficult to assess, evaluation of these systems currently indicates that the Company should not encounter Year 2000 related problems that would significantly affect the Company's ability to manufacture products. As part of the evaluation process, the Company has surveyed critical machinery, equipment and systems suppliers, and significant product and service vendors for its material real estate facilities and security systems. Responses to such surveys have not indicated any problems which, taken on their own, should materially adversely affect the Company's ability to manufacture products. The Company is continuing to follow up with suppliers and vendors who have not yet responded to the survey and has also addressed Infrastructure Systems in its contingency planning process. -27- 28 Year 2000 problems with respect to certain material customers that prevent the taking or filling of orders for products or interfere with the collections process could have a material impact on the Company's revenues. Approximately 80 percent of the Company's orders for products are delivered via electronic data interchange facilities ("EDI"). The SAP implementation is designed to address Year 2000 related issues for Company systems required for these EDI exchanges, but the Company is not able to control the EDI facilities of its customers. The Company surveyed its customer base as to their EDI facilities and their overall Year 2000 state of preparedness during the fourth quarter of 1998. The Company has received survey responses from customers who, in the aggregate, represent more than 90 percent of its 1998 revenues. The Company has also conducted Year 2000 testing of EDI with approximately 60 percent of those customers. Neither the survey results nor the testing revealed significant Year 2000 related problems which would materially impair the Company's ability to conduct EDI exchanges with its customers, although such testing should not be considered a conclusive indicator of how EDI exchanges will perform in the future. The Company is attempting to obtain survey responses from those material customers who have not yet responded and conduct testing with those remaining material customers with whom it has not yet tested prior to the end of the third quarter of 1999. The Company has also prepared an inventory and surveyed those vendors, service providers and raw materials suppliers that may have a material impact on the Company in the event of Year 2000 problems. Approximately 60 percent of the suppliers surveyed have responded and have not indicated any anticipated Year 2000 problems which, taken on their own, should significantly adversely affect operations critical to the Company's ability to realize revenues. The Company is continuing to follow up with suppliers who have not yet responded to the survey and is otherwise addressing related issues in its contingency planning process. Contingency planning for Business Systems, Infrastructure Systems and Third Party Dependencies was substantially completed during the first quarter of 1999. This process attempted to address critical Year 2000 issues presently known to the Company and other currently unanticipated (but reasonably possible) internal and external Year 2000 related events that may have a material impact on the Company's ability to conduct its operations. The Company expects to continue to revise these contingency plans as circumstances dictate during 1999. Costs to Address the Company's Year 2000 Issues The total costs associated with required modifications to address Year 2000 related issues for the Company is expected to be material to the Company's financial position. The cost of the project through March 28, 1999 was $20.2 million, all of which was related to the SAP implementation. It is not possible to identify what portion of the total SAP cost is attributable to the Year 2000 remediation. The Company planned to implement an enterprise resource planning system for its Business Systems, regardless of Year 2000 issues with respect to its former Business Systems. The future cost of the Year 2000 project is estimated to be approximately $3.5 million. All of the costs are expected to be funded through operating cash flow and bank borrowings. Risks Presented by Year 2000 Issues The Year 2000 presents a number of risks and uncertainties that could affect the Company. These include, but are not limited to, failure of the Company to identify and address material issues associated with non-SAP related Business Systems or with its Infrastructure Systems, failure or inability of customers to place orders for Year 2000 related reasons, failure of necessary raw materials manufacturers to deliver their products to the Company in a timely fashion and the inability of either the Company to collect its receivables or its customers to process payments for goods. Survey responses submitted to the Company may also be inaccurate or incomplete; however, the Company currently believes that the SAP implementation and completion of the Year 2000 project as scheduled will reduce the incidence and severity of Year 2000 related disturbances in systems that are within the control of the Company. The Company also has certain financial investments in foreign joint ventures. If the operations of these joint ventures were significantly affected by Year 2000 related issues, such could have a material adverse impact on the Company's results of operations and its financial position. Information currently known to the Company indicates that internal operations of these joint ventures should not be materially adversely affected by Year 2000 related issues; however, the Company is attempting to further confirm this information. Problems in public utilities and infrastructure systems such as power supply, telecommunications, transportation and other possible disturbances related to the Year 2000 in the United States and abroad may have unexpected, material impacts on the Company's ability to do business in the normal course and therefore may also have a material adverse impact on the Company's results of operations and financial position. Public infrastructure and -28- 29 utility systems outside of the United States are widely reported to be less adequately prepared than similar systems in the United States. Any combination of the foregoing risks or other adverse Year 2000 related events which would not in and of themselves constitute a material adverse event may, in the aggregate, materially and adversely affect the Company's results of operations, liquidity and overall financial position. All statements made herein regarding the Company's Year 2000 efforts are Year 2000 Readiness Disclosures made pursuant to the Year 2000 Information and Readiness Disclosure Act and, to the extent applicable, are entitled to the protections of such act. RISKS AND UNCERTAINTIES Increased Costs. As a part of the License Agreements entered into in connection with the Company's settlements with P&G and K-C, the Company will incur significant added costs in the form of running royalties payable to both parties for sales of the licensed diaper and training pant products. While the Company believes that the royalties being charged by P&G and K-C under their respective License Agreements are approximately the same royalties that will be paid by the Company's major store brand competitors for similar patent rights, the royalties will have a material adverse impact on the Company's future financial condition and results of operations. While these royalty costs are expected to be partially offset by projected raw material cost savings related to the conversion to a dual cuff product, the Company's overall raw material costs are expected to increase. These royalties are also expected to be partially offset by the price increases discussed below to the extent such increases are realized. In addition, as a part of the License Agreement entered into in connection with the K-C Settlement Agreement, the Company had to change to a new SAP for its diapers and training pants which exhibits certain performance characteristics. The Company has experienced product performance issues which it believes have impacted volume for the first quarter of 1999. As a result, the Company expects that it will incur increased marketing and SG&A expenditures in 1999 to address product performance issues. These increased expenditures are expected to have a material adverse impact on the Company's financial position and results of operations in 1999. The Company is encountering increased product costs due to the increased price and usage of the new SAP. While the Company is working diligently with its SAP suppliers to develop a better performing alternative, the Company cannot predict at this time whether or when such an alternative SAP will be available. The Company expects that these increased product costs will have a material adverse impact on its financial condition and results of operations for at least 1999 and potentially beyond. Reorganization. The ability of the Company to effect a successful reorganization will depend, in significant part, upon the Company's ability to formulate a plan of reorganization that is approved by the Bankruptcy Court. The Company cannot predict at this time the effect of the material adverse impact related to the increased costs described above on the Company's enterprise valuation and on a plan of reorganization for the Company. The Company believes, however, that it may not be possible to satisfy in full all of the claims against the Company. Investment in securities of, and claims against, the Company, therefore, should be regarded as highly speculative. As a result of the Chapter 11 filing, the Company has incurred and will continue to incur significant costs for professional fees as the reorganization plan is developed. The Company is also required to pay certain expenses of the Equity Committee and the Official Committee of Unsecured Creditors (together, the "Committees"), including professional fees, to the extent allowed by the Bankruptcy Court. The Company is unable to predict at this time when it will emerge from Chapter 11 protection. See "PART I: FINANCIAL INFORMATION, ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION: Chapter 11 Proceedings." Termination of License Agreements. The License Agreements with each of P&G and K-C provide that if the related Settlement Agreements are not approved, as specified in each respective agreement, by July 31, 1999 and August 1, 1999, respectively, the P&G License Agreements will become terminable at P&G's option and the K-C License Agreement will terminate automatically. If the P&G and K-C License Agreements are terminated because the respective Settlement Agreements are not approved in a timely manner, the Company could be faced with having to convert to a diaper design other than the dual cuff design covered by the licenses. At this time, the Company's only viable alternative product design is the single cuff product which is the subject of P&G's Contempt Motion in Delaware. While the Company intends to vigorously pursue approval of both settlements, it -29- 30 cannot predict when, or if, such approval will be granted. See "PART II: OTHER INFORMATION, ITEM 1: LEGAL PROCEEDINGS." Pricing. The Company announced in the fourth quarter of 1998 that it would implement a price increase of 5 percent. A significant part of this price increase is required to offset the increased costs of certain of the Company's infant care product designs. Additional price increases are needed to fully offset the added royalty cost to be incurred by the Company pursuant to the P&G and K-C settlements described above. Should the Company not be able to realize these price increases, its margins are expected to continue to be negatively impacted. Realization of Investment in Feminine Care and Adult Incontinence Business. Given the slow start up of the feminine care and adult incontinence business, which was exacerbated by the Company's Chapter 11 filing, and given the resulting feminine care and adult incontinence losses, the Company's ability to recover its investment in such business is highly uncertain. The Company's ability to recover its investment is dependent upon a prompt emergence from Chapter 11 and the successful execution of the Company's feminine care and adult incontinence business plan. The Company believes that the P&G and K-C Settlement Agreements will provide the cornerstone for what it intends to be a consensual plan of reorganization. The Company cannot predict at this time, however, when it will emerge from Chapter 11 protection. The Company believes that once it emerges from Chapter 11 the feminine care and adult incontinence business will see an increase in sales and improved results. The Company cannot predict, however, whether or when such improved results will be realized. Market for the Company's Common Stock. During 1998, the Company was notified by the New York Stock Exchange ("NYSE") that as a result of the $200 million settlement contingency and the Company's net loss in 1997, certain minimum listing requirements had not been maintained. After a review of the Company's business and prospects, the NYSE agreed to continue the Company's listing subject to future developments. There can be no assurances that the NYSE will continue to list the Company's stock. Branded Product Innovations. Because of the emphasis on product innovations in the disposable diaper, feminine care and adult incontinence markets, patents and other intellectual property rights are an important competitive factor. The national branded manufacturers have sought to vigorously enforce their patent rights. Patents held by the national branded manufacturers could severely limit the Company's ability to keep up with branded product innovations by prohibiting the Company from introducing products with comparable features. P&G and K-C have also heavily promoted diapers in the multi-pack configuration. These packages offer a lower unit price to the retailer and consumer. It is possible that the Company may continue to realize lower selling prices and/or lower volumes as a result of these initiatives. SUBSEQUENT EVENT On April 30, 1999, the Company announced that its Canadian subsidiary, Paragon Trade Brands (Canada) Inc., would cease manufacturing infant disposable diapers at its Brampton, Ontario facility. The Company anticipates recording a charge to earnings in the second quarter of 1999 in connection with costs related to this action. The Brampton plant employed approximately 113 people. The Company announced that the facility would curtail manufacturing operations over a few weeks' period of time while the Company transitions its Canadian customers to its Harmony, Pennsylvania facility. Thereafter, the Company expects that the Brampton facility will operate as a warehouse and distribution facility. FORWARD-LOOKING STATEMENTS From time to time, information provided by the Company, statements made by its employees or information included in its filings with the Securities and Exchange Commission (including the Annual Report on Form 10-K) may include statements that are not historical facts, so-called "forward-looking statements." The words "believes," "anticipates," "expects" and similar expressions are intended to identify forward-looking statements. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those expressed in the Company's forward-looking statements. Factors which could affect the Company's financial results, including but not limited to: the Company's Chapter 11 filing; increased raw material prices and product costs; new product and packaging introductions by competitors; increased price and promotion pressure from competitors; year 2000 compliance issues; and patent litigation, are described herein. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date hereof, and which are made by management pursuant to the "safe harbor" provisions of the Private Securities Litigation -30- 31 Reform Act of 1995. The Company undertakes no obligation to publicly release the result of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. NEW ACCOUNTING STANDARD In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued a Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." This statement requires capitalization of certain costs of internal-use software. The Company adopted this statement in the quarter ended March 28, 1999, and it did not have a material impact on the financial statements. In April 1998, the AICPA issued a Statement of Position 98-5, "Reporting on the Costs of Start-up Activities." This statement requires that the costs of start-up activities and organizational costs be expensed as incurred. Any of these costs previously capitalized by a company must be written off in the year of adoption. The Company adopted this statement in the quarter ended March 28, 1999, and the equity in earnings of unconsolidated subsidiaries included $.5 million in charges as a result of the adoption of the statement. ITEM 2. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK The Company's market risk-sensitive instruments and foreign currency exchange rate risks do not subject the Company to material market risk exposures. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Procter & Gamble Company v. Paragon Trade Brands, Inc. - P&G filed a lawsuit in January 1994 in the District Court for the District of Delaware alleging that the Company's "Ultra" infant disposable diaper products infringed two of P&G's dual cuff diaper patents. The lawsuit sought injunctive relief, lost profit and royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by P&G. In March 1996, the District Court granted P&G's motion for summary judgment to dismiss the Company's antitrust counterclaim. The trial was completed in February 1997, the parties submitted post-trial briefs and closing arguments were conducted on October 22, 1997. Legal fees and costs for this litigation have been significant. On December 30, 1997, the Delaware District Court issued a Judgment and Opinion finding that P&G's dual cuff patents were valid and infringed, while at the same time finding the Company's patent to be invalid, unenforceable and not infringed by P&G's products. Judgment was entered on January 6, 1998. Damages of approximately $178.4 million were entered against Paragon by the District Court on June 2, 1998. At the same time, the District Court entered injunctive relief agreed upon by P&G and the Company. The Company had previously filed with the District Court a motion under Rule 59 for a new trial or to alter or amend the Judgment. The District Court denied Paragon's motion by order entered August 4, 1998. The District Court also denied a motion by P&G seeking to recover attorneys' fees it expended in defending itself against Paragon's patent infringement counterclaim. On August 4, 1998, the Company filed with the Federal Circuit Court of Appeals its amended notice of appeal. The appeal was fully briefed, and oral argument was scheduled for February 5, 1999. On September 22, 1998, P&G filed a motion in the Delaware District Court seeking to have the Court find Paragon in contempt of the injunction entered in the case on account of Paragon's manufacture and sale of its single cuff diaper product. P&G asserted in its claim that Paragon's single cuff diaper design (i) is no more than just colorably different from the design found to infringe the P&G patents at issue in the case and (ii) also infringes such patents. The Company opposed P&G's motion. Based on the advice of counsel, the Company believes that P&G's motion is without merit. If the motion were granted, however, the Company would be forced to discontinue the manufacture and sale of its single cuff design. In addition, P&G in its motion asked that the Court order the Company to send letters to all of its customers advising them that the continued resale by them of its single cuff design would also constitute patent infringement. Consequently, the Company believes that if the motion were granted it would have a material adverse effect on the Company's financial condition and results of operations and would seriously jeopardize the Company's future viability. -31- 32 The Judgment has had a material adverse effect on the Company's financial position and its results of operations. As a result of the District Court's Judgment, the Company filed for relief under Chapter 11 of the Bankruptcy Code, 11 U.S.C. Section 101 et seq., in the United States Bankruptcy Court for the Northern District of Georgia (Case No. 98-60390) on January 6, 1998. See "--In Re Paragon Trade Brands, Inc.," below. P&G filed alleged claims in the Company's Chapter 11 reorganization proceeding ranging from approximately $2.3 billion (without trebling) to $6.5 billion (with trebling), which included a claim of $178.4 million for the Delaware Judgment. See "--In Re Paragon Trade Brands, Inc.," below. The remaining claims include claims for, among other things, alleged patent infringement by the Company in foreign countries where it has operations. On February 2, 1999, the Company entered into a Settlement Agreement with P&G which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Delaware Judgment, the Company's appeal of the Delaware Judgment, P&G's motion to find the Company in contempt of the Delaware Judgment and P&G's proof of claim filed in the Company's Chapter 11 reorganization proceeding. As a part of the P&G settlement, Paragon grants P&G an allowed unsecured prepetition claim of $158.5 million and an allowed administrative claim of $5 million. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to certain of the patents asserted by P&G in its proof of claim, including those asserted in the Delaware Action. The U.S. and Canadian patent rights licensed by the Company will allow the Company to manufacture a dual cuff baby diaper design. In exchange for these rights, the Company has agreed to pay P&G running royalties on net sales of the licensed products equal to 2 percent through October 2005, .75 percent thereafter through October 2006 and .375 percent thereafter through March 2007 in the U.S.; and 2 percent through October 2008 and 1.25 percent thereafter through December 2009 in Canada. The Settlement Agreement also provides, among other things, that P&G will grant the Company and/or its affiliates "most favored licensee" status with respect to patents owned by P&G on the date of the Settlement Agreement or for which an application was pending on that date. In addition, the Company has agreed with P&G that prior to litigating any future patent dispute, the parties will engage in good faith negotiations and will consider arbitrating the dispute before resorting to litigation. While the Company believes that the royalty rates being charged by P&G are the same royalties that will be paid by the Company's major store brand competitors for similar patent rights, these royalties, together with royalties to be paid to K-C described herein, will have a material adverse impact on the Company's future financial condition and results of operations. While these royalty costs are expected to be partially offset by projected raw material cost savings related to the conversion to a dual cuff design, the Company's overall raw material costs are expected to increase. These royalty costs are also expected to be partially offset by price increases announced by the Company in the fourth quarter of 1998 to the extent such price increases are realized. Under the terms of the P&G Settlement Agreement, the Company and P&G jointly requested modification of the injunction entered in Delaware District Court so as to allow the Company to begin converting to a dual cuff design pursuant to the License Agreements described above. The injunction was modified as requested on February 22, 1999 and the product conversion is complete. As also provided under the terms of the P&G Settlement Agreement, once a Final Order, as defined therein, has been entered by the Bankruptcy Court approving the settlement, the Company will withdraw with prejudice its appeal of the Delaware Judgment to the Federal Circuit, and P&G will withdraw with prejudice its motion in Delaware District Court to find the Company in contempt of the Delaware Judgment. A hearing on the Company's motion to seek approval from the Bankruptcy Court of this settlement was commenced on March 22 and 23, 1999 and resumed on April 13, 14 and 15, 1999. Closing arguments have been scheduled for June 8, 1999. Both the Equity Committee and K-C have objected to the P&G settlement. The Company intends to continue to pursue approval of the P&G Settlement by the Bankruptcy Court. Should the P&G Settlement Agreement not be approved by a Final Order of the Bankruptcy Court by July 31, 1999, however, the License Agreements described above will become terminable at P&G's option. The Company cannot predict when, or if, such approval will be granted. See "PART I: FINANCIAL INFORMATION, ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: Risks and Uncertainties" above. Kimberly-Clark Corporation v. Paragon Trade Brands, Inc. -- On October 26, 1995, K-C filed a lawsuit against the Company in U.S. District Court in Dallas, Texas, alleging infringement by the Company's products of two K-C patents relating to dual cuffs. The lawsuit sought injunctive relief, royalty damages, treble damages and attorneys' fees and costs. The Company denied liability under the patents and counterclaimed for patent infringement and violation of antitrust laws by K-C. Several pre-trial motions were filed by each party, including a motion for summary judgment filed by K-C with respect to the Company's antitrust counterclaim and a motion for -32- 33 summary judgment filed by the Company on one of the patents asserted by K-C. In addition, K-C sued the Company on another patent issued to K-C which is based upon a further continuation of one of the K-C dual cuff patents asserted in the case. That action was consolidated with the pending action. The Court appointed a special master to rule on the various pending motions. Legal fees and costs in connection with this litigation have been significant. As a result of the Company's Chapter 11 filing, the proceedings in the K-C litigation were stayed. The Bankruptcy Court issued an order on April 10, 1998 permitting, among other things, a partial lifting of the stay to allow the issuance of the special master's report on the items under his consideration. K-C filed with the Bankruptcy Court a motion for reconsideration of the Bankruptcy Court's April 10, 1998 order, which was denied on June 15, 1998. K-C has appealed this denial of reconsideration to the District Court for the Northern District of Georgia. The Company objected to K-C's appeal and sought to have it dismissed. K-C also filed a motion with the District Court in Atlanta to withdraw the reference with respect to all matters pertaining to its proof of claim from the jurisdiction of the Bankruptcy Court. By order executed February 18, 1999, the appeal, K-C's motion for withdrawal of the reference and the Company's motion to dismiss the appeal were dismissed by the District Court without prejudice to the right of either party within sixty days to re-open the actions if a settlement was not consummated. See "--In Re Paragon Trade Brands, Inc." below. On May 26, 1998, the special master issued his report on the majority of the motions pending before him. His report included a finding, among other things, that Paragon, as the successor-in-interest to the disposable diaper business of Pope & Talbot, has a fully paid-up license to one of the three asserted K-C inner-leg gather patents, which license runs from the date of the acquisition by the Company of Pope & Talbot. Pope & Talbot had previously obtained the license from K-C. The special master also found that K-C should be held to the narrow interpretation of its patent applied by Judge Dwyer in the Western District of Washington in earlier litigation between P&G and K-C on the patent. In addition, the special master also recommended that the Company's antitrust counterclaim and any discovery-related matters in connection therewith be dismissed. Effective September 1, 1998, the Texas action was reassigned to Judge Lindsey, a newly-appointed judge on the Dallas District Court bench. Judge Lindsey asked the parties to report on the status of the case and the likelihood of settlement. The parties responded on November 6, 1998, that negotiations were underway and that they believed considerable progress was being made. The Company has previously disclosed that should K-C prevail on its claims, an award of all or a substantial portion of the relief requested by K-C could have a material adverse effect on the Company's financial condition and its results of operations. Based on the advice of patent counsel, the Company believes that the Company's products do not infringe any valid patent asserted by K-C. K-C filed alleged claims in the Company's Chapter 11 reorganization proceeding ranging from approximately $893 million (without trebling) to $2.3 billion (with trebling). See "--In Re Paragon Trade Brands, Inc.," below. On March 19, 1999, the Company entered into a Settlement Agreement with K-C which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Texas action, including the Company's counterclaims, and K-C's proof of claim filed in the Company's Chapter 11 reorganization proceeding. Under the terms of the K-C Settlement Agreement, the Company grants K-C an allowed unsecured prepetition claim of $110 million and an allowed administrative claim of $5 million. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to the patents asserted by K-C in the Texas action. The patent rights licensed by the Company from K-C will allow the Company to manufacture a dual cuff diaper design. In exchange for these patent rights, the Company has agreed to pay K-C annual running royalties on net sales of the licensed products in the U.S. and Canada equal to: 2.5 percent of the first $200 million of net sales of the covered diaper products and 1.5 percent of such net sales in excess of $200 million in each calendar year commencing January 1999 through November 2004. The Company has agreed to pay a minimum annual royalty for diaper sales of $5 million, but amounts due on the running royalties will be offset against this minimum. The Company will also pay K-C running royalties of 5 percent of net sales of covered training pant products for the same period, but there is no minimum royalty for training pants. As part of the settlement, the Company has granted a royalty-free license to K-C for three patents which the Company in the Texas action claimed K-C infringed. While the Company believes that, based on its projected level of sales, the overall effective royalty rate that the Company will pay to K-C is less than the royalty rate that will be paid by the Company's major store brand competitors for similar patent rights, these royalties will, together with royalties to be paid to P&G described -33- 34 above, have a material adverse impact on the Company's future financial condition and results of operations. While these royalty costs are expected to be partially offset by projected raw material cost savings related to the conversion to a dual cuff product, the Company's overall raw material costs are expected to increase. These royalty costs are also expected to be partially offset by price increases announced by the Company in the fourth quarter of 1998 to the extent such price increases are realized. As a part of the K-C License Agreement, K-C has agreed not to sue the Company on two of K-C's patents related to the use of SAP in diapers and training pants, so long as the Company remains within the SAP Safe Harbor. The Company has experienced certain product performance issues the Company believes may be related to such SAP. As a result, the Company expects that it will incur increased marketing and SG&A expenditures in 1999 to address product performance issues. These increased expenditures are expected to have a material adverse impact on the Company's financial position and results of operations in 1999. The Company is encountering increased product costs due to the increased price and usage of the new SAP. While the Company is working diligently with its SAP supplier to develop a better performing alternative which is still within the SAP Safe Harbor, the Company cannot predict at this time whether or when such an alternative SAP would be available. The Company expects that these increased product costs will have a material adverse impact on its financial condition and results of operations for at least 1999 and potentially beyond. Upon the Effective Date, as defined in the K-C Settlement Agreement, K-C will dismiss with prejudice its complaint in the Texas action, as well as its related filings in the District Court in Georgia, and the Company will simultaneously dismiss with prejudice its counterclaims in the Texas action. The Company has filed a motion with the Bankruptcy Court to seek approval of the settlement and a hearing date has been set for June 9, 10 and 11, 1999. If the K-C Settlement Agreement is not approved by an order of the Bankruptcy Court entered before August 1, 1999, the K-C License Agreement described above will terminate automatically. The Company intends to vigorously pursue approval of the settlement but cannot predict when, or if, such approval will be granted. See "PART I: FINANCIAL INFORMATION, ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: Risks and Uncertainties." In Re Paragon Trade Brands, Inc. -- As described above, on December 30, 1997, the Delaware District Court issued a Judgment and Opinion in the Company's lawsuit with P&G which found, in essence, two of P&G's diaper patents to be valid and infringed by the Company's "Ultra" disposable baby diapers, while also rejecting the Company's patent infringement claim against P&G. Judgment was entered on January 6, 1998. While a final damages number was not entered by the District Court until June 2, 1998, the Company originally estimated the liability and associated litigation costs to be approximately $200 million. The amount of the award resulted in violation of certain covenants under the Company's bank loan agreements. As a result, the issuance of the Judgment and the uncertainty it created caused an immediate and critical liquidity issue for the Company which necessitated the Chapter 11 filing. Subsequently, damages of approximately $178.4 million were entered against Paragon by the District Court on June 2, 1998. At the same time, the District Court entered injunctive relief agreed upon by P&G and the Company. See "--The Procter & Gamble Company v. Paragon Trade Brands, Inc.," above. The Chapter 11 filing prevented P&G from placing liens on the Company's assets, permitted the Company to appeal the District Court's decision in an orderly fashion and affords the Company the opportunity to resolve liquidated and unliquidated claims against the Company, which arose prior to the Chapter 11 filing. The Company is currently operating as a debtor-in-possession under the Bankruptcy Code. The bar date for the filing of proofs of claim (excluding administrative claims) by creditors was June 5, 1998. P&G filed alleged claims ranging from approximately $2.3 billion (without trebling) to $6.5 billion (with trebling), which included a claim of $178.4 million for the Delaware judgment. See "--The Procter & Gamble Company v. Paragon Trade Brands, Inc.," above. The remaining claims include claims for, among other things, alleged patent infringement by the Company in foreign countries where it has operations. On February 2, 1999, the Company entered into a Settlement Agreement with P&G which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Delaware Judgment, the Company's appeal of the Delaware Judgment, P&G's motion to find the Company in contempt of the Delaware Judgment and P&G's proof of claim filed in the Company's Chapter 11 reorganization proceeding. As a part of the P&G settlement, Paragon grants P&G an allowed unsecured prepetition claim of $158.5 million and an allowed administrative claim of $5 million. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to certain of the patents asserted by P&G in its proof of claim, including those asserted in the Delaware Action. The U.S. and Canadian patent rights -34- 35 licensed by the Company will allow the Company to manufacture a dual cuff baby diaper design. In exchange for these rights, the Company has agreed to pay P&G running royalties on net sales of the licensed products equal to 2 percent through October 2005, .75 percent thereafter through October 2006 and .375 percent thereafter through March 2007 in the U.S.; and 2 percent through October 2008 and 1.25 percent thereafter through December 2009 in Canada. The Settlement Agreement also provides, among other things, that P&G will grant the Company and/or its affiliates "most favored licensee" status with respect to patents owned by P&G on the date of the Settlement Agreement or for which an application was pending on that date. In addition, the Company has agreed with P&G that prior to litigating any future patent dispute, the parties will engage in good faith negotiations and will consider arbitrating the dispute before resorting to litigation. While the Company believes that the royalty rates being charged by P&G are the same royalties that will be paid by the Company's major store brand competitors for similar patent rights, these royalties, together with royalties to be paid to K-C described below, will have a material adverse impact on the Company's future financial condition and results of operations. While these royalty costs are expected to be partially offset by projected raw material cost savings related to the conversion to a dual cuff design, the Company's overall raw material costs are expected to increase. These royalty costs are also expected to be partially offset by price increases announced by the Company in the fourth quarter of 1998 to the extent such price increases are realized. Under the terms of the P&G Settlement Agreement, the Company and P&G jointly requested modification of the injunction entered in Delaware District Court so as to allow the Company to begin converting to a dual cuff design pursuant to the License Agreements described above. The injunction was modified as requested on February 22, 1999 and the product conversion is complete. As also provided under the terms of the P&G Settlement Agreement, once a Final Order, as defined therein, has been entered by the Bankruptcy Court approving the settlement, the Company will withdraw with prejudice its appeal of the Delaware Judgment to the Federal Circuit, and P&G will withdraw with prejudice its motion in Delaware District Court to find the Company in contempt of the Delaware Judgment. A hearing on the Company's motion to seek approval from the Bankruptcy Court of this settlement was commenced on March 22 and 23, 1999 and resumed on April 13, 14 and 15, 1999. Closing arguments have been scheduled for June 8, 1999. Both the Equity Committee and K-C have objected to the P&G settlement. The Company intends to continue to pursue approval of the P&G Settlement by the Bankruptcy Court. Should the P&G Settlement Agreement not be approved by a Final Order of the Bankruptcy Court by July 31, 1999, however, the License Agreements described above will become terminable at P&G's option. The Company cannot predict when, or if, such approval will be granted. See "PART I: FINANCIAL INFORMATION, ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: Risks and Uncertainties" above. K-C filed alleged claims ranging from approximately $893 million (without trebling) to $2.3 billion (with trebling), including claims related to the litigation in the Dallas District Court described above. See "--Kimberly-Clark Corporation v. Paragon Trade Brands, Inc.," above. K-C's claims in the Bankruptcy case include an attempt to recover alleged lost profits for infringement of the patents asserted in the Dallas District Court, despite the fact that a lost profits theory of damages was not pursued by K-C in the Dallas District Court. On March 19, 1999, the Company entered into a Settlement Agreement with K-C which, if approved by the Bankruptcy Court, will fully and finally settle all matters related to the Texas action, including the Company's counterclaims, and K-C's proof of claim filed in the Company's Chapter 11 reorganization proceeding. Under the terms of the K-C Settlement Agreement, the Company grants K-C an allowed unsecured prepetition claim of $110 million and an allowed administrative claim of $5 million. As a part of the settlement, the Company has entered into License Agreements for the U.S. and Canada, which are exhibits to the Settlement Agreement, with respect to the patents asserted by K-C in the Texas action. The patent rights licensed by the Company from K-C will allow the Company to manufacture a dual cuff diaper design. In exchange for these patent rights, the Company has agreed to pay K-C annual running royalties on net sales of the licensed products in the U.S. and Canada equal to: 2.5 percent of the first $200 million of net sales of the covered diaper products and 1.5 percent of such net sales in excess of $200 million in each calendar year commencing January 1999 through November 2004. The Company has agreed to pay a minimum annual royalty for diaper sales of $5 million, but amounts due on the running royalties will be offset against this minimum. The Company will also pay K-C running royalties of 5 percent of net sales of covered training pant products for the same period, but there is no minimum royalty for training pants. As part of the settlement, the Company has granted a royalty-free license to K-C for three patents which the Company in the Texas action claimed K-C infringed. While the Company believes that, based on its projected level of sales, the overall effective royalty rate that the Company will pay to K-C is less than the royalty rate that will be paid by the Company's major store brand -35- 36 competitors for similar patent rights, these royalties will, together with royalties to be paid to P&G described above, have a material adverse impact on the Company's future financial condition and results of operations. While these royalty costs are expected to be partially offset by projected raw material cost savings related to the conversion to a dual cuff product, the Company's overall raw material costs are expected to increase. These royalty costs are also expected to be partially offset by price increases announced by the Company in the fourth quarter of 1998 to the extent such price increases are realized. As a part of the K-C License Agreement, K-C has agreed not to sue the Company on two of K-C's patents related to the use of SAP in diapers and training pants, so long as the Company remains within the SAP Safe Harbor. The Company has experienced certain product performance issues the Company believes may be related to such SAP. As a result, the Company expects that it will incur increased marketing and SG&A expenditures in 1999 to address product performance issues. These increased expenditures are expected to have a material adverse impact on the Company's financial position and results of operations in 1999. The Company is encountering increased product costs due to the increased price and usage of the new SAP. While the Company is working diligently with its SAP suppliers to develop a better performing alternative which is still within the SAP Safe Harbor, the Company cannot predict at this time whether or when such an alternative SAP would be available. The Company expects that these increased product costs will have a material adverse impact on its financial condition and results of operations for at least 1999 and potentially beyond. Upon the Effective Date, as defined in the K-C Settlement Agreement, K-C will dismiss with prejudice its complaint in the Texas action, as well as its related filings in the District Court in Georgia, and the Company will simultaneously dismiss with prejudice its counterclaims in the Texas action. The Company has filed a motion with the Bankruptcy Court to seek approval of the settlement and a hearing date has been set for June 9, 10 and 11, 1999. If the K-C Settlement Agreement is not approved by an order of the Bankruptcy Court entered before August 1, 1999, the K-C License Agreement described above will terminate automatically. The Company intends to vigorously pursue approval of the settlement but cannot predict when, or if, such approval will be granted. See "PART I: FINANCIAL INFORMATION, ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS: Risks and Uncertainties." By Order of the Bankruptcy Court on April 19, 1999, the Company's exclusivity period, during which time only the Company can propose a plan of reorganization, was extended initially to May 19, 1999. Should no interested party object by May 12, 1999, the Company's exclusivity period will automatically extend to June 19, 1999. If a timely objection is filed, a hearing is scheduled for May 17, 1999. On January 30, 1998, the Company received Bankruptcy Court approval of a $75,000 financing facility with a bank group led by The Chase Manhattan Bank. This facility is designed to supplement the Company's cash on hand and operating cash flow and to permit the Company to continue to operate its business in the ordinary course. As of March 28, 1999, there were no outstanding direct borrowings under this facility. The Company had an aggregate of $3.6 million in letters of credit issued under the DIP Credit Facility at March 28, 1999. The DIP Credit Facility contains customary covenants. The Company for a period of time had been unable to fully comply with certain reporting requirements of such covenants. The Company obtained waivers with respect to these events of default which were effective through May 10, 1999. The Company believes that it is in compliance with the reporting requirements of the DIP Credit Facility. See Note 12. Legal fees and costs in connection with the Chapter 11 case have been and will continue to be significant. The Company is unable to predict at this time when it will emerge from Chapter 11 protection. Tracy Patent - The Company had previously received notice from a Ms. Rhonda Tracy that Ms. Tracy believes the Company's diapers infringe a patent issued in August 1998 to Ms. Tracy (U.S. Patent No. 5,797,824). The Company responded, based upon advice of its independent patent counsel, that it believes its products do not infringe any valid claim of Ms. Tracy's patent. On April 29, 1999, the Company received notice that Ms. Tracy had filed suit in the United States District Court for the Northern District of Illinois against K-C, Tyco International, Ltd., Drypers Corporation and a number of the Company's customers, alleging infringement of her patent. The Company was not named as a defendant in this suit. Rather, Ms. Tracy indicated in her April 29, 1999 letter that the Company would be sued upon completion of the current suit. The Company is currently evaluating its options regarding this lawsuit, including, among other things, seeking to intervene in the suit. Other -- The Company is also a party to other legal activities generally incidental to its activities. Although the final outcome of any legal proceeding or dispute is subject to a great many variables and cannot be predicted with any degree of certainty, the Company presently believes that any ultimate liability resulting from any or all legal -36- 37 proceedings or disputes to which it is a party, except for the Chapter 11 filing and the P&G and K-C matters discussed above, will not have a material adverse effect on its financial condition or results of operations. ITEM 3. DEFAULTS IN SENIOR SECURITIES At December 28, 1997, the Company maintained a $150 million revolving credit facility with a group of nine financial institutions available through February 2001. At December 28, 1997, borrowings under this credit facility totaled $70 million. The Company also had access to short-term lines of credit on an uncommitted basis with several major banks. At December 28, 1997, the Company had approximately $50 million in uncommitted lines of credit. Borrowings under these lines of credit totaled $12.8 million at December 28, 1997. The Chapter 11 filing resulted in a default under its pre-petition revolving credit facility and borrowings under its uncommitted lines of credit. See "Note 12 of Notes to Financial Statements." ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits
EXHIBIT DESCRIPTION ------- ----------- Exhibit 3.1 Certificate of Incorporation of Paragon Trade Brands, Inc.(4) Exhibit 3.2 By-Laws of Paragon Trade Brands, Inc., as amended through July 31, 1995(5) Exhibit 4.1 Certificate of Incorporation of Paragon Trade Brands, Inc. (see Exhibit 3.1) Exhibit 10.1 Asset Transfer Agreement, dated as of January 26, 1993, by and between Weyerhaeuser and Paragon(1) Exhibit 10.2 Intellectual Property Agreement, dated as of February 2, 1993, between Weyerhaeuser and Paragon(1) Exhibit 10.3 License, dated as of February 2, 1993, between Weyerhaeuser and Paragon(1) Exhibit 10.4 Sublicense, dated as of February 2, 1993, between Weyerhaeuser and Paragon(1) Exhibit 10.5 Technology Agreement, dated as of October 15, 1987, by and between Weyerhaeuser and Johnson and Johnson, as amended(1) Exhibit 10.6.1 Letter Supply Agreement between Weyerhaeuser and Paragon dated as of October 22, 1997(9) Exhibit 10.7* Stock Option Plan for Non-Employee Directors(1) Exhibit 10.8* Annual Incentive Compensation Plan(1) Exhibit 10.9* 1993 Long-Term Incentive Compensation Plan(1) Exhibit 10.10* Employment Agreement, dated as of August 11, 1998, between Paragon and Bobby V. Abraham(12) Exhibit 10.11* Employment Agreement, dated as of August 11, 1998, between Paragon and David W. Cole(12) Exhibit 10.12* Employment Agreement, dated as of August 11, 1998, between Paragon and Alan J. Cyron(12) Exhibit 10.13* Employment Agreement, dated as of August 11, 1998, between Paragon and Arrigo D. (Rick) Jezzi(12)
-37- 38 Exhibit 10.14* Employment agreement, dated as of August 11, 1998, between Paragon and Robert E. McClain(12) Exhibit 10.15* Employment Agreement, dated as of August 11, 1998, between Paragon and Catherine O. Hasbrouck(12) Exhibit 10.16* Employment Agreement, dated as of August 11, 1998, between Paragon and Kevin P. Higgins(12) Exhibit 10.17* 1995 Incentive Compensation Plan(5) Exhibit 10.18* Paragon Trade Brands, Inc. Confirmation Retention Plan for Top Eight Executives and Summary Plan Description(12) Exhibit 10.19 Amended and Restated Credit Agreement, dated as of February 6, 1996(7) Exhibit 10.19.1 Amendment Agreement, dated December 13, 1996, to Amended and Restated Credit Agreement, dated as of February 6, 1996(8) Exhibit 10.20 Revolving Credit and Guaranty Agreement Among Paragon Trade Brands, Inc., a Debtor-in-Possession, as Borrower, the Subsidiaries of the Borrower Named Herein, as Guarantors, the Banks Party hereto, and Chase Manhattan Bank, as Agent, dated as of January 7, 1998, as Amended (Conformed to Reflect the First Amendment to the Revolving Credit and Guaranty Agreement dated as of January 30, 1998, the Second Amendment to the Revolving Credit and Guaranty Agreement dated as of March 23, 1998, and the Third Amendment to Revolving Credit and Guaranty Agreement dated as of April 15, 1998)(10) Exhibit 10.20.1 Fourth Amendment to Revolving Credit and Guaranty Agreement dated as of September 28, 1998(13) Exhibit 10.21 Security and Pledge Agreement, dated as of January 7, 1998(10) Exhibit 10.22 Revolving Canadian Credit Facility and Parent Guarantee(2) Exhibit 10.23 Indemnification Agreements, dated as of February 2, 1993, between Weyerhaeuser and Bobby V. Abraham and Gary M. Arnts(1) Exhibit 10.24 Rights Agreement dated December 14, 1994 between Paragon Trade Brands, Inc. and Chemical Bank, as Rights Agent(3) Exhibit 10.25 Asset Purchase Agreement dated December 11, 1995 by and among Paragon Trade Brands, Inc., PTB Acquisition Sub, Inc., Pope & Talbot, Inc. and Pope & Talbot, Wis., Inc.(6) Exhibit 10.26** Sales Contract, dated as of January 30, 1996, between Hoechst Celanese Corporation and Paragon Trade Brands, Inc.(7) Exhibit 10.26.1** Sales Contract, dated as of April 30, 1998, between Clariant Corporation and Paragon Trade Brands, Inc.(11) Exhibit 10.27 Lease Agreement between Cherokee County, South Carolina and Paragon Trade Brands, Inc., dated as of October 1, 1996(8) Exhibit 10.28 Settlement Agreement, dated as of February 2, 1999 between Paragon Trade Brands, Inc. and The Procter & Gamble Company(13)
-38- 39 Exhibit 10.29 U.S. License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13) Exhibit 10.30 Canadian License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13) Exhibit 10.31 U.S. License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13) Exhibit 10.32 Canadian License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13) Exhibit 10.33 Settlement Agreement, dated as of March 19, 1999 between Kimberly-Clark Corporation and Paragon Trade Brands, Inc.(13) Exhibit 10.34 License Agreement Between Kimberly-Clark Corporation and Paragon Trade Brands, Inc., dated as of March 15, 1999(13) Exhibit 10.35 License Agreement Between Kimberly-Clark Corporation and Paragon Trade Brands, Inc., dated as of March 15, 1999(13) Exhibit 11 Computation of Per Share Earnings (See Note 10 to Financial Statements) Exhibit 27 Financial Data Schedule (for SEC use only)
(b) Report on Form 8-K dated February 5, 1999. Report on Form 8-K dated March 26, 1999. - -------------------------- *Management contract or compensatory plan or arrangement. **Confidential treatment has been requested as to a portion of this document. (1) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 26, 1993. (2) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 26, 1994. (3) Incorporated by reference from Paragon Trade Brands, Inc.'s Current Report on Form 8-K, dated as of December 14, 1994. (4) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 25, 1994. (5) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 25, 1995. (6) Incorporated by reference from Paragon Trade Brands, Inc.'s Current Report on Form 8-K, dated as of February 8, 1996. (7) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1995. (8) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 29, 1996. (9) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 28, 1997. -39- 40 (10) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended March 29, 1998. (11) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 28, 1998. (12) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 27, 1998. (13) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 27, 1998. -40- 41 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PARAGON TRADE BRANDS, INC. By /s/ Alan J. Cyron ------------------------------ Alan J. Cyron Chief Financial Officer May 12, 1999 -41- 42 EXHIBIT INDEX
EXHIBIT DESCRIPTION ------- ----------- Exhibit 3.1 Certificate of Incorporation of Paragon Trade Brands, Inc.(4) Exhibit 3.2 By-Laws of Paragon Trade Brands, Inc., as amended through July 31, 1995(5) Exhibit 4.1 Certificate of Incorporation of Paragon Trade Brands, Inc. (see Exhibit 3.1) Exhibit 10.1 Asset Transfer Agreement, dated as of January 26, 1993, by and between Weyerhaeuser and Paragon(1) Exhibit 10.2 Intellectual Property Agreement, dated as of February 2, 1993, between Weyerhaeuser and Paragon(1) Exhibit 10.3 License, dated as of February 2, 1993, between Weyerhaeuser and Paragon(1) Exhibit 10.4 Sublicense, dated as of February 2, 1993, between Weyerhaeuser and Paragon(1) Exhibit 10.5 Technology Agreement, dated as of October 15, 1987, by and between Weyerhaeuser and Johnson and Johnson, as amended(1) Exhibit 10.6.1 Letter Supply Agreement between Weyerhaeuser and Paragon dated as of October 22, 1997(9) Exhibit 10.7* Stock Option Plan for Non-Employee Directors(1) Exhibit 10.8* Annual Incentive Compensation Plan(1) Exhibit 10.9* 1993 Long-Term Incentive Compensation Plan(1) Exhibit 10.10* Employment Agreement, dated as of August 11, 1998, between Paragon and Bobby V. Abraham(12) Exhibit 10.11* Employment Agreement, dated as of August 11, 1998, between Paragon and David W. Cole(12) Exhibit 10.12* Employment Agreement, dated as of August 11, 1998, between Paragon and Alan J. Cyron(12) Exhibit 10.13* Employment Agreement, dated as of August 11, 1998, between Paragon and Arrigo D. (Rick) Jezzi(12) Exhibit 10.14* Employment agreement, dated as of August 11, 1998, between Paragon and Robert E. McClain(12) Exhibit 10.15* Employment Agreement, dated as of August 11, 1998, between Paragon and Catherine O. Hasbrouck(12) Exhibit 10.16* Employment Agreement, dated as of August 11, 1998, between Paragon and Kevin P. Higgins(12) Exhibit 10.17* 1995 Incentive Compensation Plan(5)
-42- 43 Exhibit 10.18* Paragon Trade Brands, Inc. Confirmation Retention Plan for Top Eight Executives and Summary Plan Description(12) Exhibit 10.19 Amended and Restated Credit Agreement, dated as of February 6, 1996(7) Exhibit 10.19.1 Amendment Agreement, dated December 13, 1996, to Amended and Restated Credit Agreement, dated as of February 6, 1996(8) Exhibit 10.20 Revolving Credit and Guaranty Agreement Among Paragon Trade Brands, Inc., a Debtor-in-Possession, as Borrower, the Subsidiaries of the Borrower Named Herein, as Guarantors, the Banks Party hereto, and Chase Manhattan Bank, as Agent, dated as of January 7, 1998, as Amended (Conformed to Reflect the First Amendment to the Revolving Credit and Guaranty Agreement dated as of January 30, 1998, the Second Amendment to the Revolving Credit and Guaranty Agreement dated as of March 23, 1998, and the Third Amendment to Revolving Credit and Guaranty Agreement dated as of April 15, 1998)(10) Exhibit 10.20.1 Fourth Amendment to Revolving Credit and Guaranty Agreement dated as of September 28, 1998(13) Exhibit 10.21 Security and Pledge Agreement, dated as of January 7, 1998(10) Exhibit 10.22 Revolving Canadian Credit Facility and Parent Guarantee(2) Exhibit 10.23 Indemnification Agreements, dated as of February 2, 1993, between Weyerhaeuser and Bobby V. Abraham and Gary M. Arnts(1) Exhibit 10.24 Rights Agreement dated December 14, 1994 between Paragon Trade Brands, Inc. and Chemical Bank, as Rights Agent(3) Exhibit 10.25 Asset Purchase Agreement dated December 11, 1995 by and among Paragon Trade Brands, Inc., PTB Acquisition Sub, Inc., Pope & Talbot, Inc. and Pope & Talbot, Wis., Inc.(6) Exhibit 10.26** Sales Contract, dated as of January 30, 1996, between Hoechst Celanese Corporation and Paragon Trade Brands, Inc.(7) Exhibit 10.26.1** Sales Contract, dated as of April 30, 1998, between Clariant Corporation and Paragon Trade Brands, Inc.(11) Exhibit 10.27 Lease Agreement between Cherokee County, South Carolina and Paragon Trade Brands, Inc., dated as of October 1, 1996(8) Exhibit 10.28 Settlement Agreement, dated as of February 2, 1999 between Paragon Trade Brands, Inc. and The Procter & Gamble Company(13) Exhibit 10.29 U.S. License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13) Exhibit 10.30 Canadian License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13) Exhibit 10.31 U.S. License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13)
-43- 44 Exhibit 10.32 Canadian License Agreement, dated as of February 2, 1999 between The Procter & Gamble Company and Paragon Trade Brands, Inc.(13) Exhibit 10.33 Settlement Agreement, dated as of March 19, 1999 between Kimberly-Clark Corporation and Paragon Trade Brands, Inc.(13) Exhibit 10.34 License Agreement Between Kimberly-Clark Corporation and Paragon Trade Brands, Inc., dated as of March 15, 1999(13) Exhibit 10.35 License Agreement Between Kimberly-Clark Corporation and Paragon Trade Brands, Inc., dated as of March 15, 1999(13) Exhibit 11 Computation of Per Share Earnings (See Note 10 to Financial Statements) Exhibit 27 Financial Data Schedule (for SEC use only)
(b) Report on Form 8-K dated February 5, 1999. Report on Form 8-K dated March 26, 1999. - -------------------------- *Management contract or compensatory plan or arrangement. **Confidential treatment has been requested as to a portion of this document. (1) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 26, 1993. (2) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 26, 1994. (3) Incorporated by reference from Paragon Trade Brands, Inc.'s Current Report on Form 8-K, dated as of December 14, 1994. (4) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 25, 1994. (5) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 25, 1995. (6) Incorporated by reference from Paragon Trade Brands, Inc.'s Current Report on Form 8-K, dated as of February 8, 1996. (7) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1995. (8) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 29, 1996. (9) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 28, 1997. (10) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended March 29, 1998. -44- 45 (11) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended June 28, 1998. (12) Incorporated by reference from Paragon Trade Brands, Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 27, 1998. (13) Incorporated by reference from Paragon Trade Brands, Inc.'s Annual Report on Form 10-K for the fiscal year ended December 27, 1998. -45- EX-27 2 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FORM 10Q FOR THE QUARTER ENDED MARCH 28, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 3-MOS DEC-26-1999 DEC-28-1999 MAR-28-1999 25,274 0 70,272 10,948 51,999 145,013 274,744 172,542 412,609 70,272 0 0 0 124 (68,987) 412,609 126,244 126,244 109,537 109,537 0 0 102 (6,906) 313 (7,219) 0 0 0 (7,219) (.60) (.60)
-----END PRIVACY-ENHANCED MESSAGE-----