REPORT TO SHAREHOLDERS October 18, 2006 Revenue for the first quarter of 2007 increased by 5.3% or $1.1 million to $21.9 million from $20.8 million in the first quarter of 2006. Comparable store sales increased 6.0% in the same period. The Company closed two stores during this quarter and had 93 stores in operation compared to 97 stores in the same quarter last year. Gross profit as a percentage of revenue during the first quarter of 2007 increased by 0.6% to 44.0% or $12.3 million compared with 43.4% or $11.8 million during the first quarter last year. As a result of the cost reduction strategy, selling, general and administrative expenses ( SG&A ) for the first quarter of 2007 decreased by approximately $1.7 million to $16.0 million compared with $17.7 million in the first quarter of 2006. Inventory at the end of the first quarter was approximately $7.9 million higher than inventory at the end of the first quarter last year. Finished goods inventory increased by approximately $8.8 million and the entire increase is due to planned early purchases of fall merchandise. Raw material and work-in-process inventory were approximately $0.9 million lower than the first quarter of 2006. Net losses for the quarter decreased by 21.1% to $4.2 million ($0.64 per share) from $5.3 million ($0.81per share) last year. Operating losses before depreciation and amortization (EBITDA (1) ) decreased 33.2% or $2.3 million to $4.7 million from $7.1 million as compared with the same quarter last year. (1) EBITDA refers to earnings before interest expense, income tax, depreciation and amortization, and is a measure used by management to assess operating performance. EBITDA is a non-gaap earnings measure and does not have a standardized meaning. It is therefore unlikely to be comparable to similar measures presented by other issuers. Note: This Report to Shareholders may contain forward-looking statements that involve risks, estimates, and uncertainties. Therefore, actual results may differ materially. Examples of such risks and uncertainties include those associated with product sales, demand for Danier's products, availability of raw materials, foreign sourcing and manufacturing, estimates of damages, costs and interest associated with the class action lawsuit, continued growth of the leather apparel industry, and competition and other associated risks with Danier's business. For an expanded discussion of risks and uncertainties, please see the documents filed by Danier Leather Inc. with the Ontario Securities Commission. Danier disclaims any responsibility to update or revise such forward-looking statements whether as a result of new information, future events or otherwise. Investor Relations Contact Jeffrey Wortsman President and Chief Executive Officer Tel: (416) 762-8175 ext. 302 Fax: (416) 762-7408 Email: leather@danier.com -1-
CONSOLIDATED STATEMENTS OF LOSS AND RETAINED EARNINGS (thousands of dollars, except per share amounts and number of shares) For the 13 Weeks Ended September September 23, 2006 24, 2005 Revenue $ 21,928 $ 20,831 Cost of sales (Note 7) 12,281 11,785 Gross profit 9,647 9,046 Selling, general and administrative expenses (Note 7) 15,977 17,660 Interest expense (income) 57 (81) Loss before income taxes (6,387) (8,533) Recovery of income taxes (2,211) (3,242) Net loss $ (4,176) $ (5,291) Retained earnings, beginning of period $ 25,139 $ 32,214 Dividends - (393) Retained earnings, end of period $ 20,963 $ 26,530 Loss per share: Basic ($0.64) ($0.81) Diluted ($0.64) ($0.81) Weighted average number of shares outstanding: Basic 6,553,254 6,546,154 Diluted 6,560,371 6,593,762 Number of shares outstanding at period end 6,553,254 6,546,154-2-
CONSOLIDATED BALANCE SHEETS (thousands of dollars) September 23, 2006 September 24, 2005 June 24, 2006 ASSETS Current Assets Cash $ - $ 3,325 $ 11,833 Accounts receivable 1,986 1,503 402 Income taxes recoverable 4,560 3,525 2,485 Inventories (Note 3) 45,734 37,824 32,348 Prepaid expenses 931 660 1,026 Future income tax asset 534 210 529 53,745 47,047 48,623 Other Assets Property and equipment (Note 4) 26,731 26,955 27,293 Goodwill 342 342 342 Future income tax asset 5,809 5,498 5,952 $ 86,627 $ 79,842 $ 82,210 LIABILITIES Current Liabilities Bank indebtedness $ 9,302 $ - $ - Accounts payable and accrued liabilities 10,502 10,697 10,708 Current portion of capital lease obligation (Note 5) 925-911 Future income tax liability 464-624 21,193 10,697 12,243 Capital lease obligation (Note 5) 1,593-1,829 Accrued litigation provision and related expenses (Note 9) 18,000 18,000 18,000 Deferred lease inducements and rent liability 1,994 1,821 2,125 Future income tax liability 56 60 57 42,836 30,578 34,254 SHAREHOLDERS' EQUITY Share capital (Note 6) 22,542 22,493 22,542 Contributed surplus 286 241 275 Retained earnings 20,963 26,530 25,139 43,791 49,264 47,956 $ 86,627 $ 79,842 $ 82,210-3-
CONSOLIDATED STATEMENTS OF CASH FLOW (thousands of dollars) For the 13 Weeks Ended September 23, 2006 September 24, 2005 OPERATING ACTIVITIES Net loss $ (4,176) $ (5,291) Items not affecting cash: Amortization (Note 7) 1,603 1,540 Amortization of deferred lease inducements (115) (92) Amortization - other (18) - Straight line rent expense 43 75 Stock based compensation 11 11 Future income taxes (23) (655) Net change in non-cash working capital items (Note 10) (17,298) (9,905) Discontinued operations - 23 Cash flows used in operating activities (19,973) (14,294) FINANCING ACTIVITIES Dividends - (393) Repayment of obligation under capital lease (222) - Cash flows used in financing activities (222) (393) INVESTING ACTIVITIES Acquisition of capital assets (1,041) (3,181) Proceeds from sublease 160 - Repayment of lease inducement (59) - Cash flows used in investing activities (940) (3,181) Decrease in cash (21,135) (17,868) Cash, beginning of period 11,833 21,193 Cash (Bank indebtedness), end of period $ (9,302) $ 3,325 Supplementary cash flow information: Interest paid 28 - Income taxes paid - - -4-
1. SIGNIFICANT ACCOUNTING POLICIES: a) Basis of Presentation: The interim consolidated financial statements presented herein have been prepared using the same accounting policies and their methods of application as those used in the 2006 annual consolidated financial statements. Generally accepted accounting policies ( GAAP ) for interim financial statements do not conform in all respects to the disclosures required for annual financial statements, and accordingly, these interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements of Danier Leather Inc. ( the Company ) and the accompanying notes contained in the Company s 2006 Annual Report. The preparation of financial statements in conformity with Canadian GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions are based on management s best knowledge of current events and actions that the Company may undertake in the future. Significant areas requiring the use of management estimates relate to the determination of litigation award reserves, inventory valuation, realizable value of property and equipment, future income tax assets and liabilities, and the recovery of income tax. By their nature, these estimates are subject to measurement uncertainty and the impact on the consolidated financial statements of future periods from changes in estimates could be material. b) Comparative Figures Certain of the prior period s figures were reclassified to conform with the current year s financial statement presentation. 2. SEASONALITY OF RETAIL OPERATIONS: Due to the seasonal nature of the retail business and the Company s product lines, the results of operations for any interim period are not necessarily indicative of the results of operations to be expected for the fiscal year. Generally, a significant portion of the Company s sales and earnings are generated during the fiscal second quarter, which includes the holiday selling season. Sales are generally lowest and losses are experienced during the period from April to September. 3. INVENTORIES: September 23, 2006 September 24, 2005 June 24, 2006 Raw materials $ 2,676 $ 3,804 $ 1,738 Work-in-process 1,431 1,219 1,000 Finished goods 41,627 32,801 29,610 $ 45,734 $ 37,824 $ 32,348-5-
4. PROPERTY AND EQUIPMENT: Cost September 23, 2006 September 24, 2005 Net Net Accumulated Book Accumulated Book Amortization Value Cost Amortization Value Land $ 1,000 $ - $1,000 $ 1,000 $ - $ 1,000 Building 7,064 1,613 5,451 7,064 1,384 5,680 Leasehold improvements 26,485 16,266 10,219 26,901 14,582 12,319 Furniture and equipment 11,119 6,933 4,186 10,826 6,099 4,727 Computer hardware and software 8,591 5,012 3,579 9,970 6,741 3,229 Computer hardware and software under capital lease 2,920 624 2,296 - - - $57,179 $ 30,448 $26,731 $55,761 $ 28,806 $26,955 Cost June 24, 2006 Accumulated Amortization Net Book Value Land $ 1,000 $ - $1,000 Building 7,064 1,549 5,515 Leasehold improvements 25,996 15,489 10,507 Furniture and equipment 10,804 6,605 4,199 Computer hardware and software 8,353 4,763 3,590 Computer hardware and software under capital lease 2,920 438 2,482 $56,137 $28,844 $27,293 5. OBLIGATIONS UNDER CAPITAL LEASES: Future minimum lease payments required under capital leases which expire in fiscal 2009 are: 2007 $ 1,061 2008 1,061 2009 619 $ 2,741 Amounts representing interest (at a weighted average annual rate of 6.2%) 223 $ 2,518 Current portion 925 $ 1,593-6-
6. SHARE CAPITAL: (a) Authorized 1,224,329 Multiple Voting Shares Unlimited Subordinate Voting Shares Unlimited Class A and B Preference Shares (b) Issued Sep 23, 2006 Sep 24, 2005 June 24, 2006 1,224,329 Multiple Voting Shares (September 24, 2005 and June 24, 2006 1,224,329) * * * 5,328,925 Subordinate Voting Shares (September 24, 2005 5,321,825 and June 24, 2006 5,328,925) $ 22,542 $ 22,493 $ 22,542 $ 22,542 $ 22,493 $ 22,542 * Nominal The following transactions occurred during the first 13 weeks of the fiscal year with respect to the Subordinate Voting shares: 13 Weeks Ended September 23, 2006 13 Weeks Ended September 24, 2005 Number $ Number $ Shares outstanding at beginning of the period 5,328,925 $22,542 5,321,825 $22,493 Issued - - - - Repurchased - - - - Shares outstanding at end of the period 5,328,925 $22,542 5,321,825 $22,493 (c) Earnings per share Basic and diluted per share amounts are based on the following weighted average number of shares outstanding: September 23, 2006 September 24, 2005 Weighted average number of shares for basic earnings per share calculations 6,553,254 6,546,154 Effect of dilutive options outstanding 7,117 47,608 Weighted average number of shares for diluted earnings per share calculations 6,560,371 6,593,762 The computation of dilutive options outstanding only includes those options having exercise prices below the average market price of Subordinate Voting Shares during the period. The number of options excluded was 574,800 as at September 23, 2006 and 487,500 as at September 24, 2005. -7-
6. SHARE CAPITAL (continued): (d) Stock Option Plan The Company maintains a Stock Option Plan for the benefit of directors, officers and employees. As at September 23, 2006, the Company has reserved 904,175 Subordinate Voting Shares for issuance under its Stock Option Plan. As at September 23, 2006, there were 593,300 options outstanding with exercise prices ranging from $6.02 to $17.94. Of these outstanding options, 573,300 are exercisable. During the 13 week periods ended September 23, 2006 and September 24, 2005, no stock options were granted. During the 13 week period ended September 23, 2006 and September 24, 2005, 25,000 and Nil stock options were forfeited, respectively. Further details of the Stock Option Plan are contained in Note 7(e) of the consolidated financial statements contained in the Company s 2006 Annual Report. Prior to fiscal 2004, the Company used settlement accounting to account for its Stock Option Plan. No compensation cost was recorded when stock options were granted. When options were exercised, consideration paid by employees and directors was recorded in the financial statements as an increase of share capital based on the exercise price of the options. In accordance with the transitional provisions of CICA Handbook Section 3870, the Company applied the fair value based method to account for stock options on a prospective basis. Therefore, stock options granted during fiscal 2003 continue to be accounted for using the settlement accounting method and the pro-forma effect on net loss and loss per share are disclosed below. Had compensation cost been determined using the fair value-based method at the grant date of the stock options awarded to employees and directors during fiscal 2003, the pro-forma net loss and loss per share for the 13 weeks ended September 23, 2006 and September 24, 2005 would be as follows: 13 Weeks Ended September 23, 2006 13 Weeks Ended September 24, 2005 As Reported Pro-forma As Reported Pro-forma Net loss ($4,176) ($4,176) ($5,291) ($5,351) Basic loss per share ($0.64) ($0.64) ($0.81) ($0.82) Diluted loss per share ($0.64) ($0.64) ($0.81) ($0.82) The pro-forma effect on net loss of the period is not representative of the pro-forma effect on future periods because it does not take into consideration the pro-forma compensation cost related to options awarded prior to June 29, 2002. -8-
(e) Deferred Share Unit Plan Effective October 19, 2004, the Company established a Deferred Share Unit ( DSU ) Plan for nonmanagement directors. The DSU Plan is administered by the Board of Directors, with the advice of the Human Resources and Governance Committee. Under this plan, non-management directors of the Company receive an annual grant of DSUs and can also elect to receive their annual retainers and meeting fees in DSUs. A DSU is a unit equivalent in value to one Subordinate Voting Share of the Company based on the five-day average trading price of the Company s Subordinate Voting Shares on The Toronto Stock Exchange immediately prior to the date on which the value of the DSU is determined. When dividends are paid by the Company, an equivalent number of DSUs are added to the DSU account of the non-management director based on the number of DSUs in their account and the market value of the Subordinate Voting Shares on the date the dividend is paid. After retirement from the board, a participant in the DSU Plan receives a cash payment equal to the market value of the accumulated DSUs in their account. The following transactions occurred with respect to the Deferred Share Unit Plan: 13 Weeks Ended September September 23, 2006 24, 2005 (# of units) (# of units) Outstanding at beginning of period 14,904 7,317 Granted 7,000 7,200 Issued as dividend equivalents - 85 Outstanding at end of period 21,904 14,602 Danier stock price at end of period $5.90 $10.05 Liability at end of period $129 $147 (f) Restricted Share Unit Plan Effective April 20, 2005, the Company established a Restricted Share Unit ( RSU ) Plan as part of its overall executive compensation plan. The RSU Plan is administered by the Board of Directors, with the advice of the Human Resources and Governance Committee. Under this plan, Senior Officers of the Company are eligible to receive a grant of RSUs that vest on each anniversary of the grant in equal onethird instalments over a vesting period of three years. A RSU is a unit equivalent in value to one Subordinate Voting Share of the Company. When dividends are paid by the Company, an equivalent number of RSUs are added to the RSU account of the Senior Officer based on the number of RSUs in their account, the dividend paid per Subordinate Voting Share and the market value of the Subordinate Voting Shares on the date the dividend is paid. Upon the exercise of the vested RSUs, a cash payment equal to the market value of the exercised vested RSUs will be paid to the senior officer. -9-
The following transactions occurred with respect to the Restricted Share Unit Plan: 13 Weeks Ended September September 23, 2006 24, 2005 (# of units) (# of units) Outstanding at beginning of period 15,238 5,030 Issued as dividend equivalents - 30 Forfeited (5,037) - Outstanding at end of period 10,201 5,060 Danier stock price at end of period $5.90 $10.05 Liability at end of period $10 $- 7. AMORTIZATION: Amortization included in cost of sales and selling, general and administrative expenses ( SG&A ) is summarized as follows: 13 weeks ended Sep 23, 2006 Sep 24, 2005 Cost of sales $ 132 $ 146 SG&A 1,471 1,394 $ 1,603 $ 1,540 8. INCOME TAXES: The Company s effective income tax rate consists of the following: 13 weeks ended Sep 23, 2006 Sep 24, 2005 Combined basic federal and provincial average statutory rate 35.0% 35.4% Other (0.4%) 2.6% 34.6% 38.0% 9. LITIGATION PROVISION AND RELATED EXPENSES: Sep 23, 2006 Sep 24, 2005 June 24, 2006 Accrued litigation provision and related expenses $ 18,000 $ 18,000 $ 18,000 In fiscal 1999, the Company and certain of its directors and officers were served with a Statement of Claim under the Class Proceedings Act (Ontario) which made allegations about the accuracy and disclosure of certain information contained in a financial forecast issued by the Company and contained in the Prospectus it issued dated May 6, 1998 for its initial public offering ( IPO ) which closed on May 20, 1998. The suit sought damages to be paid equal to the alleged diminution in value of the Subordinate Voting Shares sold under the Prospectus. -10-
9. LITIGATION PROVISION AND RELATED EXPENSES (continued): In October 2001, a motion to certify the action as a class proceeding was granted. The trial commenced in the Superior Court of Justice (Ontario) in May 2003 and was completed in January 2004. On May 7, 2004, the trial judge issued a judgment against the Company and two of its Senior Officers in favour of the Plaintiffs and awarded damages to Canadian shareholders who purchased Subordinate Voting Shares under the Prospectus. For those shareholders who sold their shares between June 4 and 9, 1998, the trial judge awarded the difference between the IPO price and the price at which they sold their shares. For those shareholders who sold or still held their shares after June 9, 1998, the trial judge awarded $2.35 per share. Although the trial judge concluded that at the date of the Prospectus the forecast was reasonable, and that at the time of closing of the IPO the Company s CEO and CFO had an honest belief that the forecast could still be achieved, and although he held that the forecast was, in fact, substantially achieved, the trial judge decided that management s judgment that the forecast was still achievable at the time of closing was not reasonable and that therefore the Prospectus contained a misrepresentation. Based solely on information available at the time, the Company estimated that the trial judge s award would have totaled approximately $15 million. As noted below, the Company and its Senior Officers have successfully appealed this decision. In May 2005, the trial judge awarded the Plaintiffs a portion of the costs claimed for the action and referred for assessment the amount of costs to be paid. Based solely on the information available at the time, the Company estimated that these costs would have amounted to approximately $3 million to $4 million. A hearing to determine the awarding of costs related to the certification and summary judgment motion which was decided in 2000 and 2001 was held in December 2004. In June 2005, partial indemnity costs were awarded to the Plaintiffs for these motions in an amount to be assessed. The Company has appealed this decision and the appeal is still waiting to be heard. In June, 2004, a Notice of Appeal was filed by the Company and two of its Senior Officers from the trial judge s decision. The Appeal was heard by the Ontario Court of Appeal in June 2005 and in December 2005, the Court of Appeal unanimously allowed the appeal on three separate grounds, set aside the trial decision and dismissed the class proceeding. As a result, the Company and its Senior Officers are not required to pay any of the damages, interest or costs awarded by the trial judge. The Court of Appeal s decision stated that the Company had met its disclosure obligations in the Prospectus and during the IPO process and the trial judge erred in finding that any misrepresentation had occurred. In September, 2006 partial indemnity costs were awarded to the Company for the appeal in the amount of $100,000. The Court of Appeal also awarded costs to the Company for the trial on a partial indemnity basis in an amount to be determined. In February 2006, the Plaintiffs filed an Application for Leave to Appeal to the Supreme Court of Canada. In June 2006, the Supreme Court of Canada granted the Plaintiff s application. The Company expects the appeal to be heard by the Supreme Court of Canada during March 2007. Based solely on the information available at the time, if the damages, costs and interest awarded by the trial judge had been paid at the fiscal 2005 year-end, the Company estimated this amount to be approximately $18 million. During the fourth quarter of 2004, the Company recorded an expense and set up a provision of $15 million to reflect the trial judge s decision. This provision was subsequently increased by $3 million to $18 million during the fourth quarter of 2005 to take into account the trial judge s award of costs which was released in May 2005. The provision for recovery of income taxes related to the trial judge s award was based on the entire $18 million provision and the provision did not take into account the potential results of the appeal, any possible insurance recoveries or future tax adjustments. The provision for the damages award, costs and interest and the income tax recovery were based on management s best estimate and is subject to adjustment when all facts are known and all issues are resolved. The possible adjustment could be significant. Although the Court of Appeal has set aside the trial judge s decision, the provision will remain until the Supreme Court of Canada makes a final determination. -11-
10. CHANGES IN NON-CASH WORKING CAPITAL ITEMS: 13 weeks ended Sep 23, 2006 Sep 24, 2005 Decrease (increase) in: Accounts receivable ($1,584) ($408) Income taxes recoverable (2,075) (2,586) Inventories (13,386) (8,793) Prepaid expenses 95 (144) (Decrease) increase in: Accounts payable and accrued liabilities (348) 2,026 ($17,298) ($9,905) 11. CONTINGENCIES & GUARANTEES : (a) Legal proceedings In addition to the class action matter discussed in Note 9, in the course of its business, the Company from time to time becomes involved in various claims and legal proceedings. In the opinion of management, all such claims and suits are adequately covered by insurance, or if not so covered, the results are not expected to materially affect the Company s financial position. (b) Guarantees The Company has provided the following guarantees to third parties and no amounts have been accrued in the consolidated financial statements for these guarantees: (i) (ii) (iii) In the ordinary course of business, the Company has agreed to indemnify its lenders under its credit facility against certain costs or losses resulting from changes in laws and regulations or from a default in repaying a borrowing. These indemnifications extend for the term of the credit facility and do not provide any limit on the maximum potential liability. Historically, the Company has not made any indemnification payments under such agreements. In the ordinary course of business, the Company has provided indemnification commitments to certain counterparties in matters such as real estate leasing transactions, director and officer indemnification agreements and certain purchases of property and equipment such as computer software. These indemnification agreements generally require the Company to compensate the counterparties for costs or losses resulting from legal action brought against the counterparties related to the actions of the Company. The terms of these indemnification agreements will vary based on the contract and generally do not provide any limit on the maximum potential liability. The Company sublet one location during the first quarter of 2007 and one location during fiscal 2004 and has provided the landlords with guarantees in the event the sub-tenants default on their obligation to pay rent. The terms of the guarantees are between 1.25 and 2.5 years and the Company s maximum exposure is $720. -12-
12. COMMITMENTS: (a) Operating and capital leases Minimum rentals for the next five fiscal years and thereafter, excluding rentals based upon revenue are as follows: Operating Capital 2007 $10,704 $1,061 2008 9,490 1,061 2009 8,035 619 2010 5,917-2011 4,881 - Thereafter 6,852 - (b) Letters of credit The Company had outstanding letters of credit in the amount of $8,769 (September 24, 2005 - $11,508) for imports of finished goods inventories to be received. 13. SEGMENTED INFORMATION: Management has determined that the Company operates in one dominant industry and geographic segment which involves the design, manufacture and retail of fashion leather and suede apparel in Canada. -13-