Item 1. Business
General
ERO, Inc. ("ERO" or the "Company") is a leading designer, manufacturer, importer and marketer of licensed and branded Children's Leisure Products. ERO's major product areas are grouped into four business units: ERO Industries, Inc. ("ERO Industries"), which consists of Slumber Shoppe and water sports; Amav Industries, Inc. ("Amav"), which consists of children's activities, arts and crafts; Impact, Inc. ("Impact"), which consists of back-to-school products; and Priss Prints, Inc. ("Priss Prints"), which consists of children's room decor products. The Company's products are sold to all major mass merchants and big box retailers such as toy stores, office superstores, home improvement centers and specialty craft stores.
ERO is a Delaware corporation which was organized in February 1988 by certain members of ERO's management, Golder, Thoma, Cressey Fund III, Limited Partnership and other investors to acquire ERO Industries, Inc. Prior to such acquisition, ERO Industries was publicly owned and its common stock was traded on the American Stock Exchange.
Business Strategy
The Company's primary objective is to increase shareholder value. Its strategies to accomplish that goal include: pursuing the business of Children's Leisure Products, concentrating on those activities where the Company can achieve a significant competitive advantage, penetrating multiple departments of mass merchants and other efficient retailers, offering superior customer service, and pursuing growth through strategic acquisitions that complement its strategy.
The environment for selling children's products has changed dramatically during the last two decades. Five retailers now account for approximately 54% of toy sales in America, while the number of mediums companies must invest in to build a viable brand has grown with new television networks, cable television and videos. The course ERO has chosen to navigate in this environment is to "rent" great brands where the Company thinks a brand is essential, while developing the rest of its product lines to provide excellent value to the consumer with superior margin and inventory turn performance for the retailer.
In categories such as slumber, back-to-school, and children's room decor, where the brand is essential, ERO has acquired broad portfolios of licenses of the most highly promoted and advertised characters to give the Company a competitive edge. And in large activity toys and craft kits, where function is at least as important as brand, the Company has combined great engineering, capital intensity and vertical integration to put more value in its products, at substantially lower costs, in order to create a competitive advantage.
ERO also attempts to reduce the risks associated with retailer concentration by servicing multiple departments of the major retailers. In addition to the toy department, the Company sells Children's Leisure Products to the sporting goods, home improvement, stationery, domestics and juvenile departments.
Acquisitions
The Company made no acquisitions during the year ended December 31, 1996. Recent prior year acquisitions include the 1995 purchase of Amav Industries Ltd., manufacturers of children's arts, crafts and activities, the 1994 purchase of Impact International, Inc. and Impact Designs, Ltd., marketers of licensed school supplies, and the 1994 purchase of a Canadian manufacturer and distributor of licensed products.
Products
ERO Industries
Slumber Shoppe includes: slumber bags, a lightweight indoor sleeping bag for slumber parties and children's nap times; carrying cases, which are large enough to fit the slumber bags, along with pajamas, toothbrushes and other items a child might need for a "sleepover"; play tents for indoor use; and children's furniture, including foam and bean bag chairs. All of these products feature popular licensed characters, such as Mickey's Stuff for Kids, Barbie, Pooh and Batman and Robin . For the years ended December 31, 1996, 1995 and 1994, Slumber Shoppe accounted for 30%, 40% and 48% of ERO's net sales, respectively.
The water sports category includes a full range of personal flotation devices and other swim and pool products, including masks, fins, snorkels and goggles marketed under the Coral brand name. ERO's primary focus within this area is on children's water activities. The Company is the premier supplier of U.S. Coast Guard approved children's flotation products. For the years ended December 31, 1996, 1995 and 1994, water sports products accounted for 10%, 11% and 13% of ERO's net sales, respectively.
Both Slumber Shoppe and water sports products are sold to sporting goods buyers and toy buyers at major retailers. ERO's domestic manufacturing operations produce both slumber bags and flotation devices. The balance of the line is imported from contract suppliers in China, Taiwan, Italy and Indonesia.
Amav
Amav is a fully integrated manufacturer of children's products sold under the Amav brand name. Amav's products are grouped in two categories: arts and crafts, including craft kits; and activities, including game tables, easels and play kitchens. Amav manufactures over 90% of its products in an 800,000 square foot production facility in Montreal, Canada.
The acquisition of Amav in 1995 added a strong non-licensed line to ERO's existing mix of businesses. In addition, Amav added immediate growth potential with a compounded annual growth rate of more than 40% over the last six years. Amav has achieved a high level of success with its new product introductions and, due to the universal appeal of its products, is ERO's most promising vehicle for international growth.
For the years ended December 31, 1996, 1995 and 1994, Amav's products accounted for 42%, 19% and 0% of ERO's net sales, respectively.
Impact
Impact's products include a broad line of fashionable school supplies, including back packs, book bags, lunch kits, luggage, fanny packs and locker bags, and stationery products such as portfolios, binders, study kits, pencils, and theme books. Impact leverages its licensing and graphic strengths across all of these products, providing children with full sets of items featuring the characters they love. Because of the age group Impact targets, its revenues are typically derived from licensing events, such as Batman and Robin and Jurassic Park:The Lost World, rather than classic licenses. For the years ended December 31, 1996, 1995 and 1994, Impact's products accounted for 9%, 20% and 26% of ERO's net sales, respectively.
Priss Prints
Priss Prints' product line includes character-licensed stick-on and peel-off wall decorations for children's rooms. Priss' products are very popular with mothers of toddlers since they can decorate a room with the child's favorite theme in minutes. Its most popular licenses are classics such as 101 Dalmatians, Disney Babies and Pooh. For the years ended December 31, 1996, 1995 and 1994, Priss Prints products accounted for 8%, 7% and 6% of ERO's net sales, respectively.
Licenses and Licensing
An important element in ERO's marketing strategy is the ability to differentiate its products and stimulate sales by using various popular characters and well- known brand names on its products. Accordingly, ERO emphasizes the acquisition and maintenance of a broad portfolio of character licenses. Rather than attempting to select a few licenses with speculative appeal, ERO maintains multiple licenses in several categories, including classics (Mickey's Stuff for Kids, Barbie, Pooh and 101 Dalmatians) and contemporary (such as Disney's Hercules, Jurassic Park:The Lost World and Batman and Robin). ERO's brand names include Coral, Priss Prints and Amav. Sales tend to be concentrated in a limited number of character licenses in each year, although the revenue generated by any particular license varies year-to-year. For the years ended December 31, 1996, 1995 and 1994, the five licenses with the highest sales in each year accounted for approximately 30%, 49% and 65% of ERO's net sales, respectively.
ERO's license agreements are typically for two years requiring payments of approximately 10-12% of licensed product revenues. In some cases, ERO's renewal terms are based upon meeting specified sales levels, while in other cases they are based on informal understandings or arrangements. License agreements typically are subject to termination by the licensor upon failure of the licensee to meet various performance standards.
For the year ended December 31, 1996, royalties paid to licensors represented approximately 7% of ERO's consolidated net sales. Under the terms of certain license agreements, ERO is required to pay minimum guaranteed fees to the licensor over the life of the agreement. The guaranteed license fees payable by ERO have not been significant because ERO's annual percentage royalties have generally exceeded its contractual minimum requirements for its licenses.
International
The section labeled "Note 11 - Geographic Information" which appears on page 20 in the 1996 annual report is incorporated herein by reference.
For the years ended December 31, 1996, 1995, and 1994, ERO's sales to customers located outside the United States totaled $21.3 million, $11.3 million and $8.7 million, respectively.
Manufacturing and Supply
ERO currently produces slumber bags, personal flotation devices, juvenile furniture and children's room decor in its Georgia manufacturing plant. ERO's activities, arts and crafts products are produced in its Quebec and New York manufacturing facilities. The remainder of the Company's products are purchased from manufacturers located in the United States, the People's Republic of China, Taiwan, Italy and Indonesia. In 1996, ERO manufactured approximately 75% of sales in its own facilities. The Company believes that this has a positive impact on its ability to meet its customers needs for rapid response delivery with a minimum of inventory levels. In addition, because ERO's slumber products and water sports products are produced during different times of the year, ERO is able to level production costs in all of its plants during the year and, consequently, is able to minimize higher costs usually associated with seasonal facilities. ERO believes that raw materials and labor necessary to produce its products are readily available.
Competition
ERO operates in a highly competitive environment, with many other companies seeking to license characters and sell children's products to mass merchandisers. Some of these companies are larger and have greater financial resources than ERO. ERO believes that it is the largest marketer of products included in ERO Industries' Slumber Shoppe product group. ERO is one of a number of companies competing for markets with respect to products in its water sports, Impact, Priss Prints and Amav lines. In addition, ERO competes with many others for licenses to use popular characters.
Competitive factors in the market for ERO's products include characters licensed, cost, product design and quality, new product innovation and inventiveness of marketing and distribution approaches. Competitive factors in the market for character licenses include royalty levels, breadth of product lines, timely royalty reporting and payment, artistic applications and compliance with licensors' guidelines.
Employees
As of December 31, 1996, ERO had 1,195 employees. ERO believes that its future success will depend in part on its ability to continue to recruit, retain and motivate qualified employees. None of ERO's employees are represented by a labor union. ERO has not experienced any work stoppages and considers its relations with its employees to be good.
Environmental
ERO believes that its operations currently comply in all material respects with applicable federal, state and local environmental laws and regulations. ERO does not anticipate any significant expenditures in order to continue to comply with such laws and regulations.
Significant Concentration of Customers
A significant level of the Company's net sales is generated from approximately five retail companies that serve national markets. Sales to the Company's top five customers aggregated approximately 56%, 60% and 61% of net sales for the years ended December 31, 1996, 1995 and 1994, respectively. Three of the Company's customers, Toys "R" Us, Wal-Mart and Target each accounted for over 10% of the Company's net sales during 1996, 1995 and 1994, aggregating approximately 46%, 49% and 52% of net sales, respectively.
Backlog
Because the vast majority of ERO's sales are made in response to customer orders and satisfied relatively promptly, ERO's backlog is not significant.
Item 2.
Item 2. Properties
The following table provides certain information regarding the Company's principal facilities:
*This property is subject to a hypothecary claim of first rank in favor of Amav Industries Ltd. and a hypothecary claim of second rank in favor of The First National Bank of Chicago, as agent for the lenders under a credit agreement.
**This property is subject to a deed of trust in favor of The First National Bank of Chicago, as agent for the lenders under a credit agreement.
***This property is subject to security agreements in favor of the lenders to the Company.
The Company believes that its properties and equipment are in good condition and that it has sufficient capacity to meet its current manufacturing and distribution needs.
Item 3.
Item 3. Legal Proceedings
The Company is currently involved in several lawsuits arising in the ordinary course of business. The Company maintains product liability insurance and does not believe that the outcome of any such lawsuits will have a material adverse effect on the Company's financial condition. Although historically the Company has not been required to pay any material liability claims, there can be no assurance that the Company will not incur claims which are in excess of its insurance.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted during the fourth quarter of the year ended December 31, 1996.
PART II
Item 5.
Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters
The sections labeled "Note 12 - Quarterly Financial Data" and "Stockholder Information" which appear on pages 20 and 24, respectively, in the 1996 Annual Report are incorporated herein by reference. The Company has not paid cash dividends historically, and does not intend to do so in the foreseeable future.
Item 6.
Item 6. Selected Financial Data
The section labeled "Five-Year Financial Summary" which appears on page 22 in the 1996 Annual Report is incorporated herein by reference.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations
The section labeled "Management's Discussion and Analysis of Financial Conditions and Results of Operations" which appears on pages 7 and 8 in the 1996 Annual Report is incorporated herein by reference.
Item 8.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements, notes thereto and Report of Independent Accountants thereon which appear on pages 9 through 21 in the 1996 Annual Report are incorporated herein by reference.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
(a) Directors of the Registrant.
The section labeled "Election of Directors" which appears in the 1997 Proxy Statement is incorporated herein by reference.
(b) Executive Officers of the Registrant.
The following table sets forth certain information concerning the Company's executive officers: