**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-Q**

 

| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY  PERIOD ENDED JULY 3, 2004 OR** |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                   |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                |

 

**Commission file numbers:**

 

**001-31829 and 333-22155**

 

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**CARTER’S, INC.**

**THE WILLIAM CARTER COMPANY**

(Exact names of registrants as specified in their charters)

 
| **Delaware****Massachusetts**                                                         | ** ** | **13-3912933****04-1156680**          |
|---------------------------------------------------------------------------------------|------------|---------------------------------------|
| (States or other jurisdictions of  Incorporation or Organization)                     |       | (I.R.S. Employer Identification Nos.) |
|                                                                                  |
| **The Proscenium  1170 Peachtree Street NE, Suite 900  Atlanta, Georgia  30309** |
| (Address of principal executive offices, including zip code)                          |
|                                                                                  |
| **(404) 745-2700**                                                                    |
| (Registrant’s telephone number, including area code)                             |

 

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Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor 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 ý    Noo

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).    Yes o    Noý

 

The common equity of Carter’s,Inc. was not publicly traded as of the end of the second fiscal quarter of ourmost recently completed fiscal year. Accordingly, Carter’s, Inc. does not meet the definition of anaccelerated filer under Rule 12b-2 of the Securities Exchange Act of 1934.

 

Applicable only to corporateissuers:

 

Carter’s, Inc. has one class ofcommon stock.  There were 28,086,958shares of Carter’s, Inc.’s common stock, par value of $0.01 per share,outstanding as of the close of business on August 17, 2004.

 

This Form 10-Q is a combinedquarterly report being filed separately by two registrants:  Carter’s, Inc. and The William CarterCompany, the wholly-owned operating subsidiary of Carter’s, Inc.  Unless the context indicates otherwise, anyreference in this report to “TWCC” refers to The William Carter Company.“Carter’s,” “we,” “us,” and “our” refer to Carter’s, Inc. together with TWCC.

 

The William Carter Companymeets the conditions set forth in general instruction H(1)(a) and (b) of Form10-Q and is therefore filing this form with the reduced disclosure format.

 

 

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**CARTER’S, INC.**

**AND THE WILLIAM CARTER COMPANY**

**INDEX TO QUARTERLY REPORT ON FORM 10-Q**

 
| **Part I.**        | ** ** | **Financial Information**                                                                                                           | ** ** |
|--------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|
|               |       |                                                                                                                                |
|               | Item 1.    | Financial Statements                                                                                                                |       |
|               |       |                                                                                                                                |       |
|               |       | Condensed Consolidated Balance Sheets as of  July 3, 2004 (unaudited) and January 3, 2004                                           |       |
|               |       |                                                                                                                                |       |
|               |       | Unaudited Condensed Consolidated Statements  of Operations for the three and six-month periods ended July 3, 2004 and July  5, 2003 |       |
|               |       |                                                                                                                                |       |
|               |       | Unaudited Condensed Consolidated Statements  of Cash Flows for the six-month periods ended July 3, 2004 and July 5, 2003            |       |
|               |       |                                                                                                                                |       |
|               |       | Notes to the Unaudited Condensed  Consolidated Financial Statements                                                                 |       |
|               |       |                                                                                                                                |       |
|               | Item 2.    | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                         |       |
|               |       |                                                                                                                                |       |
|               | Item 3.    | Quantitative and Qualitative Disclosures  about Market Risk                                                                         |       |
|               |       |                                                                                                                                |       |
|               | Item 4.    | Controls and Procedures                                                                                                             |       |
|               |       |                                                                                                                                |
| **Part II.**       | ** ** | **Other Information**                                                                                                               | ** ** |
|               |       |                                                                                                                                |
|               | Item 1.    | Legal Proceedings                                                                                                                   |       |
|               |       |                                                                                                                                |       |
|               | Item 2.    | Change in Securities                                                                                                                |       |
|               |       |                                                                                                                                |       |
|               | Item 3.    | Defaults upon Senior Securities                                                                                                     |       |
|               |       |                                                                                                                                |       |
|               | Item 4.    | Submission of Matters to a Vote of Security Holders                                                                                 |       |
|               |       |                                                                                                                                |       |
|               | Item 5.    | Other Information                                                                                                                   |       |
|               |       |                                                                                                                                |       |
|               | Item 6.    | Exhibits and Reports on Form 8-K                                                                                                    |       |
|               |       |                                                                                                                                |       |
| **Signatures**     |       |
| ** **         |       |
| **Certifications** |       |
|                    |            |                                                                                                                                     |            |  |

 

2

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**PART I****– FINANCIAL INFORMATION**

 

**ITEM 1****. FINANCIAL STATEMENTS**

 

**CARTER’S, INC.**

**AND THE WILLIAM CARTER COMPANY**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(dollars in thousands, except for share data)

(unaudited)

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **July 3,  2004** | ** ** | **January 3,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                 |       |
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                 |       |
| Current assets:                                                                                                                                                                                                                                                                                                                                                                                   |       |              |       |                 |       |
| Cash and cash equivalents                                                                                                                                                                                                                                                                                                                                                                         |       | $                 | 13,176     |                 | $          | 36,061 |   |
| Accounts receivable, net                                                                                                                                                                                                                                                                                                                                                                          |       | 71,982            |       | 65,318               |       |
| Inventories, net                                                                                                                                                                                                                                                                                                                                                                                  |       | 148,423           |       | 104,760              |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                                                                                                                                         |       | 3,401             |       | 6,625                |       |
| Deferred income taxes                                                                                                                                                                                                                                                                                                                                                                             |       | 8,301             |       | 9,045                |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Total current assets                                                                                                                                                                                                                                                                                                                                                                              |       | 245,283           |       | 221,809              |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Property, plant, and equipment, net                                                                                                                                                                                                                                                                                                                                                               |       | 52,627            |       | 50,502               |       |
| Tradename                                                                                                                                                                                                                                                                                                                                                                                         |       | 220,233           |       | 220,233              |       |
| Cost in excess of fair value of net assets  acquired                                                                                                                                                                                                                                                                                                                                              |       | 139,282           |       | 139,282              |       |
| Licensing agreements, net of accumulated  amortization of $14,375 and $11,875                                                                                                                                                                                                                                                                                                                     |       | 625               |       | 3,125                |       |
| Deferred debt issuance costs, net                                                                                                                                                                                                                                                                                                                                                                 |       | 6,837             |       | 7,666                |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                                      |       | 2,943             |       | 3,485                |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Total assets                                                                                                                                                                                                                                                                                                                                                                                      |       | $                 | 667,830    |                 | $          | 646,102 |   |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                                                     |       |              |       |                 |       |
| Current liabilities:                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Current maturities of long-term debt                                                                                                                                                                                                                                                                                                                                                              |       | $                 | 927        |                 | $          | 3,336 |   |
| Accounts payable                                                                                                                                                                                                                                                                                                                                                                                  |       | 50,428            |       | 30,436               |       |
| Other current liabilities                                                                                                                                                                                                                                                                                                                                                                         |       | 30,429            |       | 37,405               |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Total current liabilities                                                                                                                                                                                                                                                                                                                                                                         |       | 81,784            |       | 71,177               |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Long-term debt                                                                                                                                                                                                                                                                                                                                                                                    |       | 204,002           |       | 209,377              |       |
| Deferred income taxes                                                                                                                                                                                                                                                                                                                                                                             |       | 82,293            |       | 83,196               |       |
| Other long-term liabilities                                                                                                                                                                                                                                                                                                                                                                       |       | 9,816             |       | 9,816                |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Total liabilities                                                                                                                                                                                                                                                                                                                                                                                 |       | 377,895           |       | 373,566              |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Commitments and contingencies                                                                                                                                                                                                                                                                                                                                                                     |       |              |       |                 |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                                                                                                                                        |       |              |       |                 |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Carter’s, Inc., preferred stock; par value  $.01 per share; 100,000 shares authorized; none issued or outstanding at July  3, 2004 and January 3, 2004                                                                                                                                                                                                                                       |       | —            |       | —               |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Carter’s, Inc., common stock, voting; par  value $.01 per share; 40,000,000 shares authorized; 28,073,103 shares issued  and outstanding at July 3, 2004 and 27,985,360 shares issued and outstanding  at January 3, 2004 (TWCC’s common stock, voting; par value $.01 per share;  200,000 shares authorized; 1,000 shares issued and outstanding at July 3,  2004 and January 3, 2004) |       | 281               |       | 280                  |       |
| Additional paid-in capital                                                                                                                                                                                                                                                                                                                                                                        |       | 242,948           |       | 241,780              |       |
| Retained earnings                                                                                                                                                                                                                                                                                                                                                                                 |       | 46,706            |       | 30,476               |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Total stockholders’ equity                                                                                                                                                                                                                                                                                                                                                                   |       | 289,935           |       | 272,536              |       |
|                                                                                                                                                                                                                                                                                                                                                                                              |       |              |       |                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                                                                                                                                   |       | $                 | 667,830    |                 | $          | 646,102 |   |

 

See accompanying notes to the unaudited condensed consolidatedfinancial statements

 

3

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**CARTER’S, INC.**

**AND THE WILLIAM CARTER COMPANY**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

(dollars in thousands, except for share data)

(unaudited)

 
| ** **                                             | ** ** | **For the  three-month periods ended** | ** ** | **For the  six-month periods ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                             | ** ** | **July 3,  2004**                      | ** ** | **July 5,  2003**                    | ** ** | **July 3,  2004** | ** ** | **July 5,  2003** | ** ** |
|                                                   |       |                                   |       |                                 |       |   |   |   |   |
| Net sales                                              |       | $                                      | 156,307    |                                 | $          | 140,008 |   | $ | 339,027 |   | $ | 306,001 |   |
| Cost of goods sold                                     |       | 96,716                                 |       | 90,153                               |       | 213,166 |   | 195,542 |   |
|                                                   |       |                                   |       |                                 |       |   |   |   |   |
| Gross profit                                           |       | 59,591                                 |       | 49,855                               |       | 125,861 |   | 110,459 |   |
| Selling, general, and administrative  expenses         |       | 48,024                                 |       | 41,843                               |       | 95,394 |   | 86,764 |   |
| Closure costs                                          |       | 6                                      |       | —                               |       | 540 |   | — |   |
| Royalty income                                         |       | (2,504                                 | )          | (1,903                               | )          | (5,668 | ) | (4,457 | ) |
|                                                   |       |                                   |       |                                 |       |   |   |   |   |
| Operating income                                       |       | 14,065                                 |       | 9,915                                |       | 35,595 |   | 28,152 |   |
| Interest expense, net                                  |       | 4,364                                  |       | 6,519                                |       | 8,988 |   | 13,521 |   |
|                                                   |       |                                   |       |                                 |       |   |   |   |   |
| Income before income taxes                             |       | 9,701                                  |       | 3,396                                |       | 26,607 |   | 14,631 |   |
| Provision for income taxes                             |       | 3,784                                  |       | 1,308                                |       | 10,377 |   | 5,633 |   |
|                                                   |       |                                   |       |                                 |       |   |   |   |   |
| Net income                                             |       | $                                      | 5,917      |                                 | $          | 2,088 |   | $ | 16,230 |   | $ | 8,998 |   |
|                                                   |       |                                   |       |                                 |       |   |   |   |   |
| **Carter’s, Inc.**                                |       |                                   |       |                                 |       |   |   |   |   |
| Basic net income per common share                      |       | $                                      | 0.21       |                                 | $          | 0.09 |   | $ | 0.58 |   | $ | 0.40 |   |
| Diluted net income per common share                    |       | $                                      | 0.20       |                                 | $          | 0.09 |   | $ | 0.54 |   | $ | 0.38 |   |
| Basic weighted average number of shares  outstanding   |       | 28,002,221                             |       | 22,552,137                           |       | 27,993,791 |   | 22,550,452 |   |
| Diluted weighted average number of shares  outstanding |       | 29,890,163                             |       | 24,023,255                           |       | 29,875,271 |   | 23,974,808 |   |

 

See accompanying notes to the unaudited condensed consolidatedfinancial statements

 

4

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**CARTER’S, INC.**

**AND THE WILLIAM CARTER COMPANY**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(dollars in thousands)

(unaudited)

 
| ** **                                                                     | ** ** | **For the  six-month periods ended** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                     | ** ** | **July 3,  2004**                    | ** ** | **July 5,  2003** | ** ** |
| Cash flows from operating activities:                                          |       |                                 |       |   |   |
| Net income                                                                     |       | $                                    | 16,230     |   | $ | 8,998 |   |
| Adjustments to reconcile net income to net  cash used in operating activities: |       |                                 |       |   |   |
| Depreciation and amortization                                                  |       | 10,947                               |       | 9,991 |   |
| Amortization of debt issuance costs                                            |       | 829                                  |       | 815 |   |
| Accretion of debt discount                                                     |       | 38                                   |       | 66 |   |
| Tax benefit from exercise of stock options                                     |       | 832                                  |       | — |   |
| Non-cash stock compensation expense                                            |       | 137                                  |       | — |   |
| Gain on sale of property, plant, and  equipment                                |       | (129                                 | )          | (21 | ) |
| Deferred tax benefit                                                           |       | (159                                 | )          | (2,022 | ) |
| Effect of changes in operating assets and  liabilities:                        |       |                                 |       |   |   |
| Accounts receivable                                                            |       | (6,664                               | )          | (6,304 | ) |
| Inventories                                                                    |       | (43,663                              | )          | (27,210 | ) |
| Prepaid expenses and other assets                                              |       | 3,116                                |       | (672 | ) |
| Accounts payable and other liabilities                                         |       | 13,123                               |       | (5,579 | ) |
|                                                                           |       |                                 |       |   |   |
| Net cash used in operating activities                                          |       | (5,363                               | )          | (21,938 | ) |
|                                                                           |       |                                 |       |   |   |
| Cash flows from investing activities:                                          |       |                                 |       |   |   |
| Capital expenditures                                                           |       | (10,711                              | )          | (6,810 | ) |
| Proceeds from sale of property, plant, and  equipment                          |       | 351                                  |       | 275 |   |
| Collections on loan                                                            |       | 600                                  |       | 600 |   |
|                                                                           |       |                                 |       |   |   |
| Net cash used in investing activities                                          |       | (9,760                               | )          | (5,935 | ) |
|                                                                           |       |                                 |       |   |   |
| Cash flows from financing activities:                                          |       |                                 |       |   |   |
| Payments of term loan                                                          |       | (7,822                               | )          | (5,745 | ) |
| Payments of capital lease obligations                                          |       | (140                                 | )          | (129 | ) |
| Proceeds from exercise of stock options                                        |       | 200                                  |       | — |   |
| Proceeds from sale of common stock                                             |       | —                               |       | 100 |   |
| Other                                                                          |       | —                               |       | 3,044 |   |
|                                                                           |       |                                 |       |   |   |
| Net cash used in financing activities                                          |       | (7,762                               | )          | (2,730 | ) |
|                                                                           |       |                                 |       |   |   |
| Net decrease in cash and cash equivalents                                      |       | (22,885                              | )          | (30,603 | ) |
| Cash and cash equivalents, beginning of  period                                |       | 36,061                               |       | 35,562 |   |
|                                                                           |       |                                 |       |   |   |
| Cash and cash equivalents, end of period                                       |       | $                                    | 13,176     |   | $ | 4,959 |   |

 

See accompanying notes to the unaudited condensed consolidatedfinancial statements

 

5

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**CARTER’S, INC.**

**AND THE WILLIAM CARTER COMPANY**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(unaudited)

 

**NOTE 1 –THE COMPANY:**

 

On September 30, 2003, CarterHoldings, Inc., a Massachusetts corporation re-incorporated in Delawareand changed its name by forming and subsequently merging with and into its newwholly-owned Delaware subsidiary.  Thesurviving company is named Carter’s, Inc. In connection with the re-incorporation, Carter’s, Inc. effected a4-for-1 split of its common stock.  As aresult, Carter’s, Inc.’s common stock share and per share data for all periodspresented have been adjusted to reflect this stock split.

 

Carter’s, Inc. conducts itsoperations and derives all of its operating income and cash flow through itswholly-owned subsidiary, The William Carter Company (“TWCC”).  Carter’s, Inc., together with TWCC(collectively “Carter’s,” “we,” “us,” and “our”) design, source, manufacture,and market branded childrenswear under the *Carter’s, Carter’sClassics, Child of Mine,*and*Tykes*labels.  Ourproducts are sourced through contractual arrangements with numerousmanufacturers throughout the world and through production at company-managedsewing facilities in Mexico.  Our sewingoperations in Costa Rica were closed in the fourth quarter of fiscal 2003.  (See Note 9 regarding the closure of ourCosta Rican facilities).  Products aremanufactured for wholesale distribution to major domestic retailers, includingthe mass channel, and for our 174 retail stores that market our brand namemerchandise and certain products manufactured by other companies.  Our retail operations represented approximately38.4% and 40.4% of our consolidated net sales in the second quarters of fiscal2004 and fiscal 2003 and 35.2% and 37.1% for the first six-month periods offiscal 2004 and fiscal 2003.

 

On October 29,2003, we completed an initial public offering of Carter’s, Inc.’s common stock(the “offering”) including the sale of 5,390,625 shares by us and 1,796,875shares by the selling stockholders, primarily Berkshire Partners LLC and itsaffiliates.  Net proceeds to us from theoffering totaled $93.9 million.  OnNovember 28, 2003, we used approximately $68.7 million of the proceeds toredeem approximately $61.3 million in outstanding senior subordinated notes andpay a redemption premium of approximately $6.7 million and related accruedinterest charges of $0.7 million.  Weused approximately $2.6 million of the net proceeds to terminate the BerkshirePartners LLC management agreement and used approximately $11.3 million toprepay amounts outstanding under our term loan, as required by our seniorcredit facility.  The remaining proceedswere utilized for working capital and other general corporate purposes.

 

**NOTE 2 –BASIS OF PREPARATION:**

 

The accompanying financialstatements comprise the consolidated financial statements of Carter’s, Inc. andTWCC.  Carter’s, Inc.’s only asset is itsinvestment in the common stock of TWCC, its wholly-owned subsidiary.  As a result, the consolidated financialpositions, results of operations, and cash flows of Carter’s, Inc. and TWCC aresubstantially the same.

 

In ouropinion, the accompanying unaudited condensed consolidated financial statementsof Carter’s, Inc. and TWCC contain all adjustments necessary to present fairlyour financial position as of July 3, 2004, the results of our operations forthe three and six-month periods ended July 3, 2004 and July 5, 2003, and cashflows for the six-month periods ended July 3, 2004 and July 5, 2003.  Operating results for the six-month periodended July 3, 2004 are not necessarily indicative of the results that may beexpected for the fiscal year ending January 1, 2005.  Our accompanying condensed consolidatedbalance sheet as of January 3, 2004 is from our audited consolidated financialstatements included in our most recently filed annual report on Form 10-K.

 

Certaininformation and footnote disclosure normally included in financial statementsprepared in accordance with generally accepted accounting principles in theUnited States of America has been condensed or omitted pursuant to the rulesand regulations of the Securities and Exchange Commission and the instructionsto Form 10-Q.  The accounting policies wefollow are set forth in the notes to our consolidated financial statementscontained in our most recently filed annual report on Form 10-K for the fiscalyear ended January 3, 2004.

 

6

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Our fiscalyear ends on the Saturday in December or January nearest to the last day ofDecember.  Consistent with this policy,fiscal 2003 ended on January 3, 2004 and fiscal 2004 will end on January 1,2005.  As a result, fiscal 2003 contained53 weeks of financial results and fiscal 2004 will contain 52 weeks offinancial results.  The additional weekin fiscal 2003 was included in the first half of fiscal 2003.  Therefore, the accompanying unauditedconsolidated financial statements for the first half of fiscal 2004 reflect ourfinancial position as of July 3, 2004 and for the 26-week period thenended.  The first half of fiscal 2003ended on July 5, 2003 and included 27 weeks of financial results.  The accompanying consolidated financialstatements for the second quarter periods ended July 3, 2004 and July 5, 2003each contain 13 weeks of financial results.

 

During thefirst half of fiscal 2004, we contracted with a third-party service to provideus with the fair value of co-op advertising arrangements entered into withcertain of our major wholesale and mass channel customers.  Such fair value is determined based upon,among other factors, comparable market analysis for similaradvertisements.  In accordance withEmerging Issues Task Force Issue No. 01-09, “Accounting for Consideration Givenby a Vendor to a Customer/Reseller” (“EITF 01-09”), we have included the fairvalue of these arrangements of approximately $1,221,000 in the second quarterof fiscal 2004 and $1,652,000 in the first half of fiscal 2004 as a componentof selling, general, and administrative expenses on the accompanying unauditedcondensed consolidated statements of operations rather than as a reduction ofrevenue.  Co-op advertising arrangementsin fiscal 2003 were treated as a reduction of revenue in accordance with EITF01-09 as we had determined that it was impracticable to obtain the fair valueof those arrangements.

 

**NOTE 3 –STOCK-BASED COMPENSATION:**

 

We account forstock-based compensation on stock options under the intrinsic value methodconsistent with Accounting Principles Board Opinion No. 25.  Under this method, we record compensationexpense equal to the difference between the exercise price of the stock optionand the fair market value of the underlying stock as of the date of the optiongrant.  For disclosure purposes only, wealso estimate the impact on our net income of applying the fair value method ofmeasuring compensation cost on stock options with the fair value, prior to ourinitial public offering, determined under the minimum value method as providedby Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”) as amended by SFAS No. 148,“Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS148”).  Stock options granted subsequentto our initial public offering have been valued using the Black-Scholes optionpricing model.

 

7

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The followingtable illustrates, for disclosure purposes only, the effect on net income ifcompensation expense for our option grants had been determined based on thefair value as of the grant dates consistent with the methodology of SFAS 123and SFAS 148 (dollars in thousands, except per share data):

 
| ** **                                                                                                                                                              | ** ** | **For the  three-month periods ended** | ** ** | **For the  six-month periods ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                                                              | ** ** | **July 3,  2004**                      | ** ** | **July 5,  2003**                    | ** ** | **July 3,  2004** | ** ** | **July 5,  2003** | ** ** |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Net income, as reported                                                                                                                                                 |       | $                                      | 5,917      |                                 | $          | 2,088 |   | $ | 16,230 |   | $ | 8,998 |   |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Add:                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Stock-based employee compensation (under  APB 25) included in reported net income, net of related tax effects                                                           |       | 40                                     |       | 4                                    |       | 81 |   | 8 |   |
| Deduct:                                                                                                                                                                 |       |                                   |       |                                 |       |   |   |   |   |
| Total stock-based employee compensation  expense determined under the fair value based method (under SFAS 123 and SFAS  148) for all awards, net of related tax effects |       | (304                                   | )          | (135                                 | )          | (523 | ) | (267 | ) |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Pro forma net income                                                                                                                                                    |       | $                                      | 5,653      |                                 | $          | 1,957 |   | $ | 15,788 |   | $ | 8,739 |   |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Carter’s, Inc.’s net income per common  share:                                                                                                                |       |                                   |       |                                 |       |   |   |   |   |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Basic-as reported                                                                                                                                                       |       | $                                      | 0.21       |                                 | $          | 0.09 |   | $ | 0.58 |   | $ | 0.40 |   |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Basic-pro forma                                                                                                                                                         |       | $                                      | 0.20       |                                 | $          | 0.09 |   | $ | 0.56 |   | $ | 0.39 |   |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Diluted-as reported                                                                                                                                                     |       | $                                      | 0.20       |                                 | $          | 0.09 |   | $ | 0.54 |   | $ | 0.38 |   |
|                                                                                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Diluted-pro forma                                                                                                                                                       |       | $                                      | 0.19       |                                 | $          | 0.08 |   | $ | 0.53 |   | $ | 0.36 |   |

 

For basicoptions, using a minimum value method, the fair value of each option as of thedate of grant was estimated to range from $3.08 to $9.76 per share for optionsgranted in fiscal 2003.  For basicoptions, using a fair value method, the fair value of each option at the dateof the grant was estimated to range from $12.81 to $14.15 per share for optionsgranted in fiscal 2004 and range from $6.40 to $13.55 per share for optionsgranted in fiscal 2003.  These per shareoption values were calculated at an assumed risk-free interest rate of 3.2% to4.5% for fiscal 2004 and 3.8% to 4.2% for 2003, with an expected life of 7 to10 years and expected volatility from 36.7% to 50.0%.  No dividends were assumed.

 

Forperformance options, using a minimum value method, the fair value of eachoption as of the date of grant was estimated to range from $3.08 to $9.76 pershare for options granted in fiscal 2003. For performance options, using a fair value method, the fair value ofeach option at the date of grant was estimated to range from $6.40 to $13.55per share for options granted in fiscal 2003. These per share option values were calculated at the same assumedrisk-free interest rates shown above with an expected life of 10 years andexpected volatility of 50.0%.  Nodividends were assumed.

 

8

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**NOTE 4 –INVENTORIES:**

 

Inventories consisted of the following($000):

 

| ** **                 | ** ** | **July 3,  2004** | ** ** | **January 3,  2004** | ** ** |
|----------------------------|------------|-------------------|------------|----------------------|------------|
|                       |       |              |       |                 |       |
| Finished goods             |       | $                 | 142,873    |                 | $          | 102,921 |   |
| Work in process            |       | 3,465             |       | 1,572                |       |
| Raw materials and supplies |       | 2,085             |       | 267                  |       |
|                       |       |              |       |                 |       |
| Total                      |       | $                 | 148,423    |                 | $          | 104,760 |   |

 

Results forthe second quarter of fiscal 2004 include a favorable adjustment to pre-taxincome of approximately $1.5 million, or $933,000, net of tax, to correctadjustments made to inventory and cost of goods sold during fiscal 2003 and thefirst quarter of fiscal 2004.  Wedetermined such adjustments to be immaterial to prior periods affected; accordingly,they were corrected in the second quarter of fiscal 2004.  Had such adjustments been corrected in theperiods they were initially recorded, net income for fiscal 2003 would havebeen $24.3 million, or 4.4% higher than reported.  First quarter fiscal 2004 net income wouldhave been $10.1 million, or 2.4% lower than reported and there would have beenno material impact to the consolidated balance sheets or consolidatedstatements of cash flows.

 

**NOTE 5 –STOCK TRANSACTIONS OF CARTER’S, INC:**

 

During thefirst quarter of fiscal 2004, we issued 220,000 options, and during the secondquarter of fiscal 2004, we issued 71,200 options to purchase Carter’s, Inc.’scommon stock to certain employees. During the first quarter of fiscal 2003, we issued 76,800 options topurchase Carter’s, Inc.’s common stock to one of our directors and to certainemployees.  Additionally, during thesecond quarter of fiscal 2003, we sold shares of our common stock to one of ourdirectors for cash proceeds of $100,000. In connection with this transaction, we recorded contributions to ouradditional paid-in capital in the amount of $100,000.

 

Nocompensation expense was recorded during the first or second quarters of fiscal2004 and fiscal 2003 as a result of these option grants or stock purchase, asthe stock was purchased at its fair market value and the options were issued asof the date of grant with an exercise price equal to the fair market value of ashare of stock.

 

During the second quarter of fiscal 2004, certain employees exercised87,743 options for cash proceeds of $200,000.

 

**NOTE 6 –GOODWILL AND OTHER INTANGIBLE ASSETS:**

 

In connectionwith our 2001 acquisition by Berkshire Partners LLC and affiliates (the“Acquisition”), as more fully described in Note 1 “The Company” to ourconsolidated financial statements in our most recently filed annual report onForm 10-K, we adopted provisions of SFAS No. 141, “Business Combinations” andapplied the required provisions of SFAS No. 142, “Goodwill and Other IntangibleAssets.”  Accordingly, our tradename andgoodwill have been deemed to have indefinite lives and are no longer beingamortized.  Our licensing agreements arebeing amortized over the average three-year life of such agreements.  Amortization expense for the second quartersand first six-month periods of fiscal 2004 and 2003 was $1.3 and $2.5 million,respectively, and is expected to be $3.1 million for fiscal 2004.

 

9

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**NOTE 7 –EMPLOYEE BENEFIT PLANS:**

 

We offer a comprehensive post-retirement medical plan to current andcertain future retirees and their spouses until they become eligible forMedicare or a Medicare supplement plan. We also offer life insurance to current and certain future retirees.  See Note 7 “Employee Benefit Plans” to theconsolidated financial statements in our most recently filed annual report onForm 10-K for further information.

 

The components of pension benefit expense charged to operations are asfollows ($000):

 
| ** **                                                            | ** ** | **For the  three-month periods ended** | ** ** | **For the  six-month periods ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                            | ** ** | **July 3,  2004**                      | ** ** | **July 5,  2003**                    | ** ** | **July 3,  2004** | ** ** | **July 5,  2003** | ** ** |
|                                                                  |       |                                   |       |                                 |       |   |   |   |   |
| Service cost – benefits attributed to  service during the period |       | $                                      | —     |                                 | $          | — |   | $ | — |   | $ | — |   |
| Interest cost on accumulated pension  benefit obligation              |       | 20                                     |       | 22                                   |       | 39 |   | 43 |   |
| Amortization of prior service cost                                    |       | —                                 |       | —                               |       | — |   | 32 |   |
| Amortization of net actuarial loss                                    |       | —                                 |       | 16                                   |       | — |   | — |   |
| Total net periodic pension benefit cost                               |       | $                                      | 20         |                                 | $          | 38 |   | $ | 39 |   | $ | 75 |   |

 

The components of post-retirement life and medical benefit expensecharged to operations are as follows ($000):

 
| ** **                                                            | ** ** | **For the  three-month periods ended** | ** ** | **For the  six-month periods ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                            | ** ** | **July 3,  2004**                      | ** ** | **July 5,  2003**                    | ** ** | **July 3,  2004** | ** ** | **July 5,  2003** | ** ** |
|                                                                  |       |                                   |       |                                 |       |   |   |   |   |
| Service cost – benefits attributed to  service during the period |       | $                                      | 25         |                                 | $          | 20 |   | $ | 47 |   | $ | 40 |   |
| Interest cost on accumulated  post-retirement benefit obligation      |       | 156                                    |       | 157                                  |       | 306 |   | 315 |   |
| Amortization of net actuarial loss                                    |       | —                                 |       | —                               |       | — |   | — |   |
| Total net periodic post-retirement benefit  cost                      |       | $                                      | 181        |                                 | $          | 177 |   | $ | 353 |   | $ | 355 |   |

 

**NOTE 8 –SEGMENT INFORMATION:**

 

We report segmentinformation in accordance with the provisions of SFAS No. 131, “Disclosureabout Segments of an Enterprise and Related Information” (“SFAS 131”), whichrequires segment information to be disclosed based upon a “managementapproach.”  The management approachrefers to the internal reporting that is used by management for makingoperating decisions and assessing the performance of our reportablesegments.  During the third quarter offiscal 2003, we revised our methodology for evaluating and reporting profitability.  Additionally, as a result of the launch ofour *Child of Mine* brand withWal-Mart in June of 2003, we have expanded our presence in the mass channelresulting in a new segment of our business.

 

Under ourprevious method of evaluating and reporting the profitability of our segments,each segment’s results included costs directly related to the segment’srevenue, and all other costs were allocated based on the relationship toconsolidated net sales or units produced to support each segment’s revenue.  Intersegment sales and transfers wererecorded at cost and treated as a transfer of inventory.  Under our new methodology, segment resultsinclude the direct costs of each segment (on the same basis as the previousmethodology), and all other costs are allocated based upon detailed estimatesand analysis of actual time and expenses incurred to support the operations ofeach segment or units produced or sourced to support

 

10

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each segment’s revenue.  Certain costs, including incentivecompensation for certain employees, the Berkshire Partners LLC management fee(terminated in connection with our initial public offering, see Note 1 to theunaudited condensed consolidated financial statements), and various othergeneral corporate costs that are not specifically allocable to our segments,are included in other reconciling items below. Intersegment sales and transfers continue to be recorded at cost andtreated as a transfer of inventory. Prior period segment information has been reclassified to conform withthe current presentation.  The accountingpolicies of the segments are the same as those described in Note 2 “Summary ofSignificant Accounting Policies” to the consolidated financial statements inour most recently filed annual report on Form 10-K.

 

The table below presents certain segment information for the periodsindicated ($000):

 
| ** **              | ** ** | **For the  three-month periods ended** | ** ** | **For the  six-month periods ended** | ** ** |
|-------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **              | ** ** | **July 3,  2004**                      | ** ** | **% of  Total**                      | ** ** | **July 5,  2003** | ** ** | **% of  Total** | ** ** | **July 3,  2004** | ** ** | **% of  Total** | ** ** | **July 5,  2003** | ** ** | **% of  Total** | ** ** |
|                    |       |                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Net sales:**          |       |                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Wholesale               |       | $                                      | 73,535     |                                 | 47.0       | % | $ | 65,633 |   | 46.9 | % | $ | 164,088 |   | 48.4 | % | $ | 162,232 |   | 53.0 | % |
| Retail                  |       | 59,994                                 |       | 38.4                                 | %          | 56,579 |   | 40.4 | % | 119,235 |   | 35.2 | % | 113,521 |   | 37.1 | % |
| Mass Channel            |       | 22,778                                 |       | 14.6                                 | %          | 17,796 |   | 12.7 | % | 55,704 |   | 16.4 | % | 30,248 |   | 9.9 | % |
| Total net sales         |       | $                                      | 156,307    |                                 | 100.0      | % | $ | 140,008 |   | 100.0 | % | $ | 339,027 |   | 100.0 | % | $ | 306,001 |   | 100.0 | % |
|                    |       |                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **EBITDA:**             |       |                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Wholesale               |       | $                                      | 11,408     |                                 | 58.0       | % | $ | 7,483 |   | 50.0 | % | $ | 27,767 |   | 59.7 | %  | $ | 26,429 |   | 69.3 | %  |
| Retail                  |       | 11,530                                 |       | 58.6                                 | %          | 11,380 |   | 76.1 | % | 22,524 |   | 48.4 | % | 22,058 |   | 57.8 | % |
| Mass Channel            |       | 2,666                                  |       | 13.6                                 | %          | 1,213 |   | 8.1 | % | 8,053 |   | 17.3 | % | 1,071 |   | 2.8 | % |
| Other reconciling items |       | (5,930                                 | )          | (30.2                                | %)         | (5,119 | ) | (34.2 | %) | (11,802 | ) | (25.4 | %) | (11,415 | ) | (29.9 | %) |
| Total EBITDA            |       | $                                      | 19,674     |                                 | 100.0      | % | $ | 14,957 |   | 100.0 | % | $ | 46,542 |   | 100.0 | % | $ | 38,143 |   | 100.0 | % |

 

EBITDA shownabove represents earnings before interest, income tax expense, depreciation,and amortization.  EBITDA is presentedbecause it is one measurement used by management in assessing financialperformance, and we believe it is helpful to investors, securities analysts,and other interested parties in evaluating performance of companies in ourindustry.  EBITDA is also a measure usedas a basis for calculating our financial covenants under our senior creditfacility.  EBITDA is not a measurement offinancial performance under generally accepted accounting principles in theUnited States of America.  It should notbe considered as an alternative to cash flow from operating activities, as ameasure of liquidity, an alternative to net income, or any other measures ofperformance derived in accordance with generally accepted accounting principlesin the United States of America.  Ourdefinition and calculation of EBITDA may not be comparable to similarly titledmeasures used by other companies.

 

A reconciliation of EBITDA to net income is presented below ($000):

 
| ** **                             | ** ** | **For the  three-month periods ended** | ** ** | **For the  six-month periods ended** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                             | ** ** | **July 3,  2004**                      | ** ** | **July 5,****2003**                  | ** ** | **July 3,  2004** | ** ** | **July 5,  2003** | ** ** |
|                                   |       |                                   |       |                                 |       |   |   |   |   |
| Total EBITDA                           |       | $                                      | 19,674     |                                 | $          | 14,957 |   | $ | 46,542 |   | $ | 38,143 |   |
| Depreciation and amortization  expense |       | (5,609                                 | )          | (5,042                               | )          | (10,947 | ) | (9,991 | ) |
| Interest expense, net                  |       | (4,364                                 | )          | (6,519                               | )          | (8,988 | ) | (13,521 | ) |
| Provision for income taxes             |       | (3,784                                 | )          | (1,308                               | )          | (10,377 | ) | (5,633 | ) |
| Net income                             |       | $                                      | 5,917      |                                 | $          | 2,088 |   | $ | 16,230 |   | $ | 8,998 |   |

 

11

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**NOTE 9 –CLOSURE COSTS:**

 

OnJuly 3, 2004, we closed our distribution facility located in Leola,Pennsylvania in order to consolidate its shipping operations with our remainingthree distribution facilities in Georgia. This closure was announced to affected employees on June 1, 2004.  Total employees terminated as of July 3, 2004were 33.  As a result of this closure, werecorded approximately $95,000 in severance costs during the second quarter andfirst half of fiscal 2004.  During thethird and fourth quarters of fiscal 2004, we expect to incur approximately$200,000 in additional severance and other exit costs.

 

In July 2003, we decided to exit our sewingfacilities located in Costa Rica given our ability to obtain lower costs fromthird-party suppliers.  Such closures wereannounced on September 16, 2003, and the facilities were held and used forproduction through the end of November 2003. Total employees terminated as of July 3, 2004 were approximately 1,492.

 

As a result of the CostaRican closures, we recorded approximately $1,306,000 in accelerateddepreciation during the third and fourth quarters of fiscal 2003 (included incost of goods sold) and plant closure costs of approximately $1,041,000comprised of $184,000 of asset impairment charges, $483,000 of severance, and$374,000 in other exit costs.  We alsoincurred approximately $424,000 in the fourth quarter of fiscal 2003 and$11,000 in the first quarter of fiscal 2004 of federal income tax expenserelated to the dissolution of our Costa Rican subsidiary (included in theprovision for income taxes).

 

Activityassociated with the closure cost reserves for our Costa Rican sewing facilityand our distribution facility in Leola, Pennsylvania for the three andsix-month periods ended July 3, 2004 is as follows:

 
| ** **                               | ** ** | **January 3,  2004  Reserves** | ** ** | **Provisions** | ** ** | **Payments** | ** ** | **April 3,  2004  Reserves** | ** ** | **Provisions** | ** ** | **Payments** | ** ** | **July 3,  2004  Reserves** | ** ** |
|------------------------------------------|------------|--------------------------------|------------|----------------|------------|--------------|------------|------------------------------|------------|----------------|------------|--------------|------------|-----------------------------|------------|
|                                     |       |                           |       |           |       |         |       |                         |       |           |       |         |       |                        |       |
| Severance and other termination benefits |       | $                              | 274,000    |           | $          | 210,000      |       | $                            | (256,000   | )              | $          | 228,000      |       | $                           | (41,000    | ) | $ | (87,000 | ) | $ | 100,000 |   |
| Other exit costs                         |       | —                         |       | 324,000        |       | (324,000     | )          | —                       |       | 47,000         |       | (47,000      | )          | —                      |       |
|                                     |       |                           |       |           |       |         |       |                         |       |           |       |         |       |                        |       |
| Total                                    |       | $                              | 274,000    |           | $          | 534,000      |       | $                            | (580,000   | )              | $          | 228,000      |       | $                           | 6,000      |   | $ | (134,000 | ) | $ | 100,000 |   |

 

12

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**NOTE 10 –EARNINGS PER SHARE:**

 

In accordance with SFAS No. 128, “Earnings Per Share,” basicearnings per share is based on the weighted average number of common sharesoutstanding during the period, whereas diluted earnings per share also giveseffect to all potentially dilutive common shares, which include stock options,that were outstanding during the period. All such stock options are reflected in the denominator using thetreasury stock method.  This methodassumes that shares are issued for options that are “in the money,” but that weuse the proceeds of such option exercises (generally, cash to be paid plusfuture compensation expense to be recognized) to repurchase shares at theaverage market value of our shares for the respective periods.  We have used our best estimate of the averagemarket value of our shares for the respective periods prior to our initialpublic offering completed on October 29, 2003.

 

The following is a reconciliation of basic number of common sharesoutstanding to diluted number of common and common equivalent sharesoutstanding:

 
| ** **                                                                                              | ** ** | **For the  three-month periods ended** | ** ** | **For the  six-month periods ended** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                              | ** ** | **July 3,  2004**                      | ** ** | **July 5,  2003**                    | ** ** | **July 3,  2004** | ** ** | **July 5,  2003** | ** ** |
|                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Net income                                                                                              |       | $                                      | 5,917,000  |                                 | $          | 2,088,000 |   | $ | 16,230,000 |   | $ | 8,998,000 |   |
| Carter’s, Inc.’s weighted average number of  common and common equivalent shares outstanding: |       |                                   |       |                                 |       |   |   |   |   |
| Basic number of common shares outstanding                                                               |       | 28,002,221                             |       | 22,552,137                           |       | 27,993,791 |   | 22,550,452 |   |
| Dilutive effect of stock options                                                                        |       | 1,887,942                              |       | 1,471,118                            |       | 1,881,480 |   | 1,424,356 |   |
| Diluted number of common and common  equivalent shares outstanding                                      |       | 29,890,163                             |       | 24,023,255                           |       | 29,875,271 |   | 23,974,808 |   |
|                                                                                                    |       |                                   |       |                                 |       |   |   |   |   |
| Basic net income per common shares                                                                      |       | $                                      | 0.21       |                                 | $          | 0.09 |   | $ | 0.58 |   | $ | 0.40 |   |
| Diluted net income per common shares                                                                    |       | $                                      | 0.20       |                                 | $          | 0.09 |   | $ | 0.54 |   | $ | 0.38 |   |

 

13

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| **ITEM 2.** | ** ** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION****AND RESULTS OF OPERATIONS:** |
|-------------|------------|----------------------------------------------------------------------------------------------------|

 

The following is a discussion of our results of operations and currentfinancial position.  You should read thisdiscussion in conjunction with our unaudited condensed consolidated financialstatements and notes included elsewhere in this quarterly report.  Actual results may differ materially fromthose suggested by our forward-looking statements for various reasons includingthose discussed in the section entitled “Risks Factors” in our final prospectusdated October 23, 2003.  Those riskfactors expressly qualify all subsequent oral and written forward-lookingstatements attributable to us or persons acting on our behalf.  Except for any ongoing obligations todisclose material information as required by the federal securities laws, we donot have any intention or obligation to update forward-looking statements afterwe file this quarterly report.

 

Our fiscal year ends on the Saturday in December or January nearest tothe last day of December.  Consistentwith this policy, fiscal 2003 ended on January 3, 2004 and fiscal 2004 will endon January 1, 2005.  As a result, fiscal2003 contained 53 weeks of financial results and fiscal 2004 will contain 52weeks of financial results.  Theadditional week in fiscal 2003 was included in the first half of fiscal2003.  Therefore, the accompanying unauditedcondensed consolidated financial statements for the first half of fiscal 2004reflect our financial position as of July 3, 2004 and for the 26-week periodthen ended.  The first half of fiscal2003 ended on July 5, 2003 and included 27 weeks of financial results.  The three-month periods ended July 3, 2004and July 5, 2003 each contained 13 weeks of financial results.

 

**RESULTS OFOPERATIONS**

 

The followingtable sets forth, for the periods indicated, (i) selected statement ofoperations data expressed as a percentage of net sales and (ii) the number ofretail stores open at the end of each period:

 
| ** **                                     | ** ** | **Three-month periods ended** | ** ** | **Six-month periods ended** | ** ** |
|------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| ** **                                     | ** ** | **July 3,  2004**             | ** ** | **July 5,  2003**           | ** ** | **July 3,  2004** | ** ** | **July 5,  2003** | ** ** |
|                                           |       |                          |       |                        |       |   |   |   |   |
| Wholesale sales                                |       | 47.0                          | %          | 46.9                        | %          | 48.4 | % | 53.0 | % |
| Retail sales                                   |       | 38.4                          |       | 40.4                        |       | 35.2 |   | 37.1 |   |
| Mass Channel sales                             |       | 14.6                          |       | 12.7                        |       | 16.4 |   | 9.9 |   |
|                                           |       |                          |       |                        |       |   |   |   |   |
| Net sales                                      |       | 100.0                         |       | 100.0                       |       | 100.0 |   | 100.0 |   |
| Cost of goods sold                             |       | 61.9                          |       | 64.4                        |       | 62.9 |   | 63.9 |   |
|                                           |       |                          |       |                        |       |   |   |   |   |
| Gross profit                                   |       | 38.1                          |       | 35.6                        |       | 37.1 |   | 36.1 |   |
| Selling, general, and administrative  expenses |       | 30.7                          |       | 29.9                        |       | 28.1 |   | 28.4 |   |
| Closure costs                                  |       | —                        |       | —                      |       | 0.2 |   | — |   |
| Royalty income                                 |       | (1.6                          | )          | (1.4                        | )          | (1.7 | ) | (1.5 | ) |
|                                           |       |                          |       |                        |       |   |   |   |   |
| Operating income                               |       | 9.0                           |       | 7.1                         |       | 10.5 |   | 9.2 |   |
| Interest expense, net                          |       | 2.8                           |       | 4.7                         |       | 2.7 |   | 4.4 |   |
|                                           |       |                          |       |                        |       |   |   |   |   |
| Income before income taxes                     |       | 6.2                           |       | 2.4                         |       | 7.8 |   | 4.8 |   |
| Provision for income taxes                     |       | 2.4                           |       | 0.9                         |       | 3.0 |   | 1.9 |   |
|                                           |       |                          |       |                        |       |   |   |   |   |
| Net income                                     |       | 3.8                           | %          | 1.5                         | %          | 4.8 | % | 2.9 | % |
|                                           |       |                          |       |                        |       |   |   |   |   |
| Number of retail stores at end of period       |       | 174                           |       | 159                         |       | 174 |   | 159 |   |

 

14

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**Three andsix-month periods ended July 3, 2004 compared to three and six-month periodsended July 5, 2003**

 

*NET SALES.*  In the second quarter of fiscal 2004,consolidated net sales increased $16.3 million, or 11.6%, to $156.3 millionfrom $140.0 million in the second quarter of fiscal 2003.  This increase for the second quarter offiscal 2004 over the prior year was driven by growth in each of our channels ofdistribution.  In the first half offiscal 2004, consolidated net sales were $339.0 million, an increase of $33.0million, or 10.8%, as compared with $306.0 million for the first half of fiscal2003.  The increase in the first half offiscal 2004 over the prior year primarily reflects growth in sales to the masschannel, including sales of our *Child ofMine* brand to Wal-Mart, which launched in June of 2003, and growthin sales in our retail channel.

 

Totalwholesale sales increased $7.9 million, or 12.0%, to $73.5 million in the secondquarter of fiscal 2004 from $65.6 million in the second quarter of fiscal2003.  Wholesale sales, excludingoff-price sales, increased $10.1 million, or 17.2%, to $68.6 million from $58.5million in the second quarter of fiscal 2003, driven by growth in each of ourbaby, playwear, and sleepwear product categories.  Sales growth in our baby and playwear productcategories has resulted from our focus on improving core products.  Increased sleepwear sales were driven by ourfocus on improved product design and sourcing capabilities.  In the first half of fiscal 2004, wholesalesales increased $1.9 million, or 1.1%, to $164.1 million from $162.2 million inthe first half of fiscal 2003.  Wholesalesales, excluding off-price sales in the first half of fiscal 2004, increased$3.4 million, or 2.2%, to $155.3 million from $151.9 million in the first halfof fiscal 2003.  The increase inwholesale sales for the first half of fiscal 2004 was driven primarily bystrong sleepwear sales.

 

Mass channelsales in the second quarter of fiscal 2004 increased $5.0 million, or 28.0%, to$22.8 million from $17.8 million in the second quarter of fiscal 2003.  Mass channel sales in the first half offiscal 2004 increased $25.5 million, or 84.2% to $55.7 million from $30.2 millionin the first half of fiscal 2003.  Thisrevenue growth for the second quarter and first half of fiscal 2004 primarilyreflects sales of our *Child of Mine*brand that began selling to Wal-Mart in the latter part of the second quarterof fiscal 2003.  Also contributing tothis growth were increased sales of the *Tykes*brand sold to Target.

 

Retail storesales were $60.0 million for the second quarter of fiscal 2004, an increase of$3.4 million, or 6.0%, from $56.6 million in the second quarter of fiscal 2003.  Comparable store sales for the second quarterof fiscal 2004, based on 158 locations, were flat compared to the secondquarter of fiscal 2003.  The primarydriver of the revenue increase was incremental revenue generated fromnew stores opened subsequent to July 5, 2003, offset by the impact of storesclosed over the last twelve months.  Inthe first half of fiscal 2004, retail store sales increased $5.7 million, or5.0%, to $119.2 million from $113.5 million in the first half of fiscal2003.  Such revenue growth was driven byincremental sales of $7.4 million generated from new stores opened subsequentto July 5, 2003 and a comparable store sales increase of $1.9 million, or 1.8%,based on 158 locations.  Such increaseswere partially offset by the impact of store closures of $0.5 million and anadditional week of selling in the first half of fiscal 2003 of $3.1million.  There were a total of 174stores as of July 3, 2004.  We plan toopen five stores and close four stores during the balance of fiscal 2004.  We do not expect to incur any significantcosts as a result of these store closures.

 

*GROSS PROFIT.*  Our gross profit increased $9.7 million, or19.5%, to $59.6 million in the second quarter of fiscal 2004 from $49.9 millionin the second quarter of fiscal 2003. Gross profit as a percentage of net sales in the second quarter offiscal 2004 increased to 38.1% from 35.6% in the second quarter of fiscal 2003due to improved product costs and lower levels of customer accommodations resultingfrom improved product performance. Additionally, as described in Note 4 to the accompanying unauditedcondensed consolidated financial statements, we recorded a favorable adjustmentof $1.5 million to correct adjustments to cost of sales and inventory madeduring fiscal 2003 and the first quarter of fiscal 2004.  Gross profit increased $15.4 million, or13.9%, to $125.9 million in the first half of fiscal 2004 compared to $110.5million in the first half of fiscal 2003. As a percentage of net sales, gross profit in the first half of fiscal2004 increased to 37.1% from 36.1% in the first half of fiscal 2003.  This increase in gross profit, relative tosales, for the first half of fiscal 2004 resulted primarily from favorable productcosts, lower levels of inventory provisions due to our focus on core products,and the inventory adjustment, noted above, offset by a higher mix of masschannel revenues that generally yield lower margins than our wholesale andretail channels.

 

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*SELLING, GENERAL, AND ADMINISTRATIVEEXPENSES.*   Selling, general, and administrative expenses for the second quarter offiscal 2004 increased $6.2 million, or 14.8%, to $48.0 million from $41.8million in the second quarter of fiscal 2003. Selling, general, and administrative expenses, as a percentage of netsales, increased to 30.7% in the second quarter of fiscal 2004 from 29.9% inthe second quarter of fiscal 2003.  Thisincrease was driven primarily by growth in distribution costs and the classificationof co-operative advertising expenses as further described in Note 2 to theaccompanying unaudited condensed consolidated financial statements.  In the first half of fiscal 2004, selling,general, and administrative expenses increased $8.6 million, or 9.9%, to $95.4million from $86.8 million in the first half of fiscal 2003.  As a percentage of net sales, these expensesdecreased to 28.1% in the first half of fiscal 2004 from 28.4% in the firsthalf of fiscal 2003.  Such improvementsreflect the benefit of operating leverage.

 

*CLOSURE COSTS*.    In June of 2004, we decided to exit ourdistribution facility in Leola, Pennsylvania in order to consolidate ourdistribution operations and reduce costs. We recorded approximately $95,000 of severance costs during the secondquarter and first half of fiscal 2004.

 

In July of2003, we decided to exit our Costa Rican sewing facilities, given our abilityto obtain lower costs from third-party suppliers.  During the second quarter of fiscal 2004, wereversed approximately $136,000 of severance costs and other terminationbenefits previously estimated for this closure and recorded approximately $47,000of other closure costs.  In the firsthalf of fiscal 2004, we recorded approximately $74,000 of severance and $371,000of other closure costs.

 

*ROYALTY INCOME.*    We license the use of our *Carter’s, Carter’s Classics,*and*Child of Mine*names and sublicense the*Tykes*name to certain licensees.  Our royalty income in the second quarter offiscal 2004 increased $0.6 million, or 31.6%, to $2.5 million compared to $1.9million in the second quarter of fiscal 2003. During the first half of fiscal 2004, royalty income was approximately$5.7 million, an increase of $1.2 million, or 27.2%, over the first half offiscal 2003.  The increases in the secondquarter and first half of fiscal 2004 resulted primarily from royalties earnedon licensed sales of our *Child of Mine*brand by our licensee partners who began shipping their products during thethird quarter of fiscal 2003.

 

*OPERATING INCOME.   *Operating incomefor the second quarter of fiscal 2004 increased $4.2 million, or 41.9%, to$14.1 million compared to $9.9 million in the second quarter of fiscal2003.  As a percentage of net sales,operating income increased to 9.0% in the second quarter of fiscal 2004compared to 7.1% in the second quarter of fiscal 2003.  Operating income for the first half of fiscal2004 increased $7.4 million to $35.6 million from $28.2 million in the first halfof fiscal 2003.  Operating income, as apercentage of net sales, increased to 10.5% in the first half of fiscal 2004compared to 9.2% in the first half of fiscal 2003.  These increases in operating income for the second quarter and first half of fiscal2004 reflect the benefit from revenue growth, increases in gross profit, andleveraging of operating expenses, described above.

 

*INTEREST EXPENSE*, *NET*.   Interest expense in the second quarter of fiscal 2004 decreased $2.2million, or 33.1%, to $4.4 million compared to $6.5 million in the secondquarter of fiscal 2003.  In the firsthalf of fiscal 2004, interest expense decreased $4.5 million to $9.0 millionfrom $13.5 million in the first half of fiscal 2003.  These decreases are attributable to theredemption of approximately $61.3 million of our 10.875% senior subordinatednotes in the fourth quarter of fiscal 2003, lower variable interest rates onreduced levels of term loan indebtedness, and the additional week of interestin the first half of fiscal 2003.

 

*INCOME TAXES.   *We recorded a provisionfor income taxes of $3.8 million in the second quarter of fiscal 2004 comparedto $1.3 million in the second quarter of fiscal 2003.  In the first half of fiscal 2004, we recordeda provision for income taxes of $10.4 million compared to $5.6 million in thefirst half of fiscal 2003.  Our effectivetax rate was approximately 39.0% during the second quarter and first half offiscal 2004 and 38.5% during the second quarter and first half of fiscal 2003.

 

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*NET INCOME.   *As a result of the factors noted above, oursecond quarter 2004 net income was approximately $5.9 million, compared toapproximately $2.1 million in the second quarter of fiscal 2003.  Net income for the first half of fiscal 2004was $16.2 million compared to $9.0 million in the first half of fiscal 2003.

 

**FINANCIALCONDITION, CAPITAL RESOURCES, AND LIQUIDITY**

 

Our cash needs are working capital, capital expenditures, and debtservice.  Historically, we have financedthese needs through internally generated cash flow and funds borrowed under oursenior credit facility.  Our primarysource of liquidity will continue to be cash flow from operations andborrowings available under our revolving loan facility, and we expect thatthese sources will fund our ongoing requirements for debt service and capitalexpenditures.  These sources of liquiditymay be impacted by continued demand for our products and our ability to meetdebt covenants under our credit facility.

 

Net accountsreceivable at July 3, 2004 were $72.0 million compared to $59.9 million at July5, 2003 and $65.3 million at January 3, 2004. The increase over July 5, 2003 reflects higher levels of revenue in thelatter part of the second quarter of fiscal 2004 as compared to the end of thesecond quarter of fiscal 2003.  Due tothe seasonal nature of our operations, the net accounts receivable balance atJuly 3, 2004 is not comparable to the net accounts receivable balance atJanuary 3, 2004.

 

Netinventories at July 3, 2004 were $148.4 million compared to $132.9 million atJuly 5, 2003 and $104.8 million at January 3, 2004.  This increase over July 5, 2003 was plannedto support third quarter fiscal 2004 shipping requirements.  Due to the seasonal nature of our operations,net inventories at July 3, 2004 are not comparable to net inventories atJanuary 3, 2004.

 

Net cash usedin operating activities for the first half of fiscal 2004 was $5.4 millioncompared to net cash used in operating activities of $21.9 million in the firsthalf of fiscal 2003.  The change in netcash used in operating activities in the first half of fiscal 2004 compared tothe first half of fiscal 2003 is primarily attributable to increases inaccounts payable and the growth in earnings, partially offset by increasedlevels of inventory.

 

We haveinvested $10.7 million in capital expenditures during the first half of fiscal2004 compared to $6.8 million during the first half of fiscal 2003.  We plan to invest an additional $13.8 millionin capital expenditures during the remainder of fiscal 2004.  Major investments include the expansion ofour distribution capabilities, retail store openings and remodeling, andfixturing programs for wholesale and mass channel customers.

 

On October 29, 2003, we completed an initial public offering ofCarter’s, Inc.’s common stock including the sale of 5,390,625 shares by us and1,796,875 shares by the selling stockholders, primarily Berkshire Partners LLCand its affiliates.  Net proceeds to us fromthe offering totaled $93.9 million.  OnNovember 28, 2003, we used approximately $68.7 million of the proceeds toredeem approximately $61.3 million in outstanding senior subordinated notes andpay a redemption premium of approximately $6.7 million and related accruedinterest charges of $0.7 million.  Weused approximately $2.6 million of the net proceeds to terminate the BerkshirePartners LLC management agreement and used approximately $11.3 million toprepay amounts outstanding under our term loan as required by our senior creditfacility.  We used remaining proceeds forworking capital and other general corporate purposes.

 

Effective July29, 2003, our credit facility was amended to, among other things, increase theamount of the commitments under the revolving loan facility from $60.0 millionto $80.0 million; provide for a 75 basis point reduction in the applicableinterest margin by prepaying our existing Tranche B term loan and replacing itwith a new Tranche C term loan; and reduce the amount of our mandatory loanprepayment requirement from 50% or 75% of excess cash flow to 25% or 50% ofexcess cash flow, depending on the applicable leverage ratio.  Pursuant to the amendment, we are alsopermitted to repurchase up to $15.0 million of additional senior subordinatednotes, which we may consider from time to time.

 

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Our seniorcredit facility, as amended, sets forth mandatory and optional prepaymentconditions that may result in our use of cash to reduce our debt obligations,including payments of:  (i) 50% of thenet cash proceeds from an equity issuance by Carter’s, Inc., excluding, amongother things, any issuance of equity in connection with employee or directorstock plans or a permitted acquisition and (ii) 25% or 50% of consolidatedexcess cash flow, depending on the applicable leverage ratio, as both terms aredefined in the amended senior credit facility. The terms of the consolidated excess cash flow condition were effectivefor fiscal 2002, and accordingly, we made a principal prepayment ofapproximately $4.8 million on March 26, 2003 and approximately $2.4 million onMarch 22, 2004.  This excess cash flowcondition may result in future annual prepayments depending on the consolidatedexcess cash flow generated in each year. The lenders will apply such prepayments first to the term loan and,second, to permanently reduce our revolving loan facility.  Subject to certain conditions in our seniorcredit facility, we may make optional prepayments of our debt obligationswithout premium or penalty.  The lenderswill apply such optional prepayments according to our instruction.

 

On March 22, 2004, we prepaid an additional $5.0 million of term loanindebtedness.  At July 3, 2004, we hadapproximately $204.9 million of debt outstanding, consisting of$113.1 million of senior subordinated notes (the “Notes”),$91.8 million in term loan borrowings, and no borrowings under ourrevolving loan facility, exclusive of approximately $16.6 million ofoutstanding letters of credit.  At July3, 2004, we had approximately $63.4 million of financing available under ourrevolving loan facility.  At January 3,2004, we had approximately $212.7 million of debt outstanding, consistingof $113.1 million of Notes, $99.6 million in term loan borrowings andno revolver borrowings, exclusive of approximately $6.5 million ofoutstanding letters of credit.  Therevolver will be available to fund our working capital requirements, capitalexpenditures, and other general corporate purposes.

 

After givingeffect to the prepayments of our term loan described above, principalborrowings under our term loan are due and payable in thirteen quarterlyinstallments of $231,792 from September 30, 2004 through September 30, 2007 andfour quarterly payments of approximately $22.2 million from December 31, 2007through September 30, 2008.  Interest onour term loan is payable at the end of interest rate reset periods, which varyin length but in no case exceed six months. The outstanding balance of our revolving loan facility is payable infull on August 15, 2006, and interest is payable quarterly, or more frequentlyin the event we have chosen a Eurodollar rate option available under the termsof our senior credit facility.  Noprincipal payments are required on the Notes prior to their scheduled maturityin August 2011.  Beginning August 15, 2006, we may redeem allor part of the Notes as further described in Note 5 to our most recently filedannual report on Form 10-K.  Interestis payable semi-annually on the Notes in February and August of each year.  Prior to the completion of our initial publicoffering, our semi-annual interest payment on the Notes was $9.5 million foreach payment.  After giving effect to theredemption of $61.3 million of the principal amount of the Notes in November 2003, our semi-annualinterest payment is now approximately $6.2 million.

 

As previouslyprovided by a management agreement with Berkshire Partners LLC, we agreed,among other things, to pay Berkshire Partners an annual management fee of $1.65million per year for four years, commencing on the first anniversary of our2001 acquisition.  We paid this feequarterly, in advance.  As describedabove, upon completion of our initial public offering, this management feeagreement was terminated.

 

Based on ourcurrent level of operations and anticipated cost savings and operatingimprovements, we believe that cash generated from operations and availablecash, together with amounts available under our revolving loan facility, willbe adequate to meet our debt service requirements, capital expenditures, andworking capital needs for the foreseeable future, although no assurance can begiven in this regard.  We may, however,need to refinance all or a portion of the principal amount of the Notes on orprior to maturity in 2011.

 

Our seniorcredit facility imposes certain covenants, requirements, and restrictions onactions by us and our subsidiaries that, among other things, restrict thepayment of dividends.

 

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**EFFECTS OFINFLATION AND DEFLATION**

 

We areaffected by inflation and changing prices primarily through the purchase of rawmaterials, increased operating costs and expenses, and fluctuations in interestrates.  The effects of inflation on ournet sales and operations have not been material in recent years.  In recent years, there has been deflationarypressure on selling prices.  While wehave been successful in offsetting such deflationary pressures through productimprovements and lower costs with the expansion of our global sourcing network,if deflationary pricing trends outpace our ability to obtain further pricereductions from our global suppliers and other cost reduction initiatives, ourprofitability may be affected.

 

**SEASONALITY**

 

We experience seasonal fluctuations in our sales and profitability,with generally lower sales and gross profit in the first and second quarters ofour fiscal year.  Over the past fivefiscal years, approximately 57% of our consolidated net sales were generated inthe second half of our fiscal year.  Accordingly, our results of operations for thefirst and second quarters of any year are not indicative of the results weexpect for the full year.

 

Asa result of this seasonality, our inventory levels and other working capitalrequirements generally begin to increase during the second quarter and into thethird quarter of each year.  During thesepeak periods we have historically borrowed under the revolver.

 

**CRITICALACCOUNTING POLICIES AND ESTIMATES**

 

Our discussion and analysisof our financial condition and results of operations are based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America.  The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues, expenses, and related disclosure of contingentassets and liabilities.  We base ourestimates on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  Actual results may differ from theseestimates under different assumptions or conditions.

 

Our significant accounting policies aredescribed in Note 2 to our consolidated financial statements contained in ourmost recently filed annual report on Form 10-K. The following discussion addresses our critical accounting policies,which are those that require management’s most difficult and subjectivejudgments, often as a result of the need to make estimates about the effect ofmatters that are inherently uncertain.

 

*Revenue recognition:** ***Werecognize wholesale and mass channel revenue after shipment of products tocustomers, when title passes and when all risks and rewards of ownership havetransferred.  In certain cases, in whichwe retain the risk of loss during shipment, revenue recognition does not occuruntil the goods have reached the specified customer.  We consider revenue realized or realizableand earned when the product has been shipped and when all risks and rewards ofownership have transferred, the sales price is fixed or determinable, andcollectibility is reasonably assured.  Inthe normal course of business, we grant certain accommodations and allowancesto our wholesale and mass channel customers. Such amounts are reflected as reductions of net sales.  Retail store revenues are recognized at thepoint of sale.  We reduce revenue forcustomer returns and deductions.  We alsomaintain an allowance for doubtful accounts for estimated losses resulting fromthe inability of our customers to make payments and reserve for certainaccommodations and allowances that we have granted to our wholesale and masschannel customers.  If the financialcondition of our customers were to deteriorate, resulting in an impairment of theirability to make payments, an additional allowance could be required.

 

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During thefirst half of fiscal 2004, we contracted with a third-party service to provideus with the fair value of co-op advertising arrangements entered into with certainof our major wholesale and mass channel customers.  Such fair value is determined based upon,among other factors, comparable market analysis for similaradvertisements.  In accordance withEmerging Issues Task Force Issue No. 01-09, “Accounting for Consideration Givenby a Vendor to a Customer/Reseller” (“EITF 01-09”), we have included the fairvalue of these arrangements of approximately $1,221,000 in the second quarterof fiscal 2004 and $1,652,000 in the first half of fiscal 2004 as a component ofselling, general, and administrative expenses on the accompanying unauditedcondensed consolidated statement of operations rather than as a reduction ofrevenue.  Co-op advertising arrangementsin fiscal 2003 were treated as a reduction of revenue in accordance with EITF01-09 as we had determined that it was impracticable to obtain the fair valueof those arrangements.

 

*Inventory: *We provide reserves for slow-moving inventoryequal to the difference between the cost of inventory and the estimated marketvalue based upon assumptions about future demand and market conditions.  If actual market conditions are lessfavorable than those we project, additional write-downs may be required.

 

*Goodwill and tradename:*  As of July 3, 2004, we had approximately $360million in goodwill and tradename assets. The fair value of the *Carter’s*tradename was estimated at the Acquisition to be approximately $220 millionusing a discounted cash flow analysis, which examined the hypothetical costsavings that accrue as a result of our ownership of the tradename.  The cash flows, which incorporated bothhistorical and projected financial performance, were discounted using adiscount rate of 12%.  The tradename wasdetermined to have an indefinite life. The carrying value of these assets is subject to annual impairmentreviews as of the last day of each fiscal year. Factors affecting such impairment reviews include the continued marketacceptance of our offered products and the development of new products.  Impairment reviews may also be triggered byany significant events or changes in circumstances.  Our impairment review of goodwill is based onthe estimated fair values of the underlying businesses.  These estimated fair values are based onestimates of the future cash flows of the businesses.

 

*Accrued expenses: *Accrued expenses forhealth insurance, workers compensation, incentive compensation, professionalfees, and other outstanding obligations are assessed based on actualcommitments, statistical trends, and estimates based on projections and currentexpectations, and these estimates are updated periodically as additionalinformation becomes available.

 

*Accounting for income taxes:*  As part of the process of preparing ourconsolidated financial statements, we are required to estimate our actualcurrent tax exposure (state, federal, and foreign), together with assessingpermanent and temporary differences resulting from differing bases andtreatment of items for tax and accounting purposes, such as the carrying valueof intangibles, deductibility of expenses, depreciation of property, plant, andequipment, and valuation of inventories. Temporary differences result in deferred tax assets and liabilities,which are included within our consolidated balance sheets.  We must then assess the likelihood that ourdeferred tax assets will be recovered from future taxable income.  Actual results could differ from thisassessment if sufficient taxable income is not generated in future periods.  To the extent we determine the need to establisha valuation allowance or increase such allowance in a period, we must includean expense within the tax provision in the accompanying unaudited condensedconsolidated statement of operations.

 

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*Stock-basedcompensation arrangements: *Weaccount for stock-based compensation on stock options under the intrinsic valuemethod, whereby we record compensation expense equal to the difference betweenthe exercise price of the stock option and the fair market value of theunderlying stock at the date of the option grant.  For disclosure purposes only, we alsoestimate the impact on our net income of applying the fair value method ofmeasuring compensation cost on stock options with the fair value, prior to ourinitial public offering, determined under the minimum value method as providedby Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accountingfor Stock-Based Compensation” as amended by SFAS No. 148, “Accounting forStock-Based Compensation-Transition and Disclosure.”  For stock issued or sold outright toemployees, directors, or third parties, we measure expense as the differencebetween the price paid by the recipient and the fair market value of the stockon the date of issuance or sale.  Priorto our initial public offering, in the absence of a public market for Carter’s,Inc.’s common stock, management and the Board of Directors estimated the marketvalue of Carter’s, Inc.’s common stock for all option grants and stockissuances using an approach that applies a multiple to Adjusted EBITDA.  Adjusted EBITDA represents earnings beforeinterest, income tax expense, depreciation and amortization, and also excludesAcquisition-related charges, write-downs of long-lived assets, closure costs,and a deferred charge write-off. Adjusted EBITDA is not a measurement under accounting principlesgenerally accepted in the United States of America.

 

**FORWARDLOOKING STATEMENTS**

 

Statements contained herein that relate toour future performance, including, without limitation, statements with respectto our anticipated results of operations or level of business for fiscal 2004or any other future period, are forward-looking statements within the meaningof the safe harbor provisions of the Private Securities Litigation Reform Actof 1995.  Such statements are based oncurrent expectations only and are subject to certain risks, uncertainties, andassumptions.  Should one or more of theserisks or uncertainties materialize, or should underlying assumptions prove incorrect,actual results may vary materially from those anticipated, estimated, orprojected.  Among the factors that couldcause actual results to materially differ include a decrease in sales to or theloss of one or more of our key customers, downward pressure on our prices,disruptions in foreign supply sources, negative publicity, the loss of one ormore of our major suppliers for raw materials, increased competition in thebaby and young children’s apparel market, our substantial leverage which increasesour exposure to interest rate risk and could require us to dedicate asubstantial portion of our cash flow to repay principal, the impact ofgovernmental regulations and environmental risks applicable to our business,and seasonal fluctuations in the children’s apparel business.  These risks are described in our finalprospectus dated October 23, 2003 under the headings “Risk Factors,”  “Business-Competition; Certain Risks,” and“Statement Regarding Forward-Looking Statements.”  We undertake no obligation to publicly updateor revise any forward-looking statements, whether as a result of newinformation, future events, or otherwise.

 

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**ITEM 3.****                               QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

In the operation of ourbusiness, we have market risk exposures including those related to foreigncurrency risk and interest rates.  Theserisks and our strategies to manage our exposure to them are discussed below.

 

We contract for productionwith third parties primarily in the Far East and South and CentralAmerica.  While these contracts arestated in United States dollars, there can be no assurance that the cost forthe future production of our products will not be affected by exchange ratefluctuations between the United States dollar and the local currencies of thesecontractors.  Due to the number ofcurrencies involved, we cannot quantify the potential impact of future currencyfluctuations on net income in future years. In order to manage this risk, we source products from approximately 100vendors worldwide, providing us with flexibility in our production shouldsignificant fluctuations occur between the United States and various localcurrencies.  To date, such exchangefluctuations have not had a material impact on our financial condition orresults of operations.  We do not hedgeforeign currency exchange rate risk.

 

Our operating results aresubject to risk from interest rate fluctuations on our debt, which carriesvariable interest rates.  At July 3,2004, our outstanding debt aggregated $204.9 million, of which $91.8 millionbore interest at a variable rate, so that an increase of 1% in the applicablerate would increase our annual interest cost by $918,000 and could have anadverse effect on our net income and cash flow. Pursuant to the provisions of our senior credit facility, we purchasedan interest rate cap as an economic hedge against approximately $31.3 millionof variable rate debt.  The cap rate is7.0%, and the arrangement expires on December 7, 2004.

 

**OTHER RISKS**

 

There also areother risks in the operation of our business specifically related to rawmaterial pricing and our global sourcing network.

 

The principal raw materialswe use are finished fabrics and trim materials. Prices for these materials are affected by changes in market demand, andthere can be no assurance that prices for these and other raw materials willnot increase in the near future.  Thesematerials are available from more than one supplier, which enables us to negotiatepricing.  However, the loss of one ormore of these suppliers could temporarily interrupt our supply, which couldhave an adverse effect on our sales and increase our costs.

 

We currently sourcesubstantially all of our production from our offshore operations andthird-party manufacturers located in foreign countries.  As a result, we may be adversely affected bypolitical instability resulting in the disruption of trade from foreigncountries, the imposition of new regulations relating to imports, duties,taxes, and other charges on imports, any significant decreases in the value ofthe dollar against foreign currencies, and restrictions on the transfer offunds.  These and other factors couldresult in the interruption of production in offshore facilities, delay receiptof the products into the United States, or affect our operating income.  Our future performance may be subject to suchfactors, which are beyond our control, and there can be no assurance that suchfactors would not have a material adverse effect on our financial condition andresults of operations.  We carefullyselect our sourcing agents, and in an effort to mitigate the possibledisruption in product flow, we place production in various countries we believeto be of lower risk.

 

We continually evaluate opportunities to improve our products andreduce our costs.  Our remaining sewingfacilities, located in Mexico, currently provide us with an advantageous coststructure.  If we determine in the futurethat we are able to source products currently sewn in Mexico at a significantlylower cost with superior quality elsewhere, we would develop a plan to exitsuch facilities and incur substantial closure-related costs.

 

Weenter into various purchase order commitments with full-package suppliers.  We can cancel these arrangements, although insome instances, we may be subject to a termination charge reflecting apercentage of work performed prior to cancellation.  Historically, such cancellations and relatedtermination charges have occurred infrequently and have not had a materialimpact on our business. However, as we rely more heavily on our full-packageglobal sourcing network, we expect to incur more of these termination charges,which could increase our cost of goods sold.

 

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**ITEM 4.****                              ****CONTROLS AND PROCEDURES**

 

The Chief Executive Officerand Chief Financial Officer of Carter’s, Inc. and TWCC have evaluated theeffectiveness of the design and operation of our disclosure controls and procedures(as defined under Rules 13a-15(e) and 15d-15(e) promulgated under theSecurities Exchange Act of 1934, as amended) as of the end of the periodcovered by this report.  Based upon thatevaluation, the Chief Executive Officer and Chief Financial Officer ofCarter’s, Inc. and TWCC have concluded that our disclosure controls andprocedures are adequate and effective.

 

We have recently implementeda policy that requires an additional monthly review by management of allinventory-related journal entries exceeding $500,000.

 

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**PART II****– OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS:**

 

From time totime, we have been involved in various legal proceedings.  We believe that all such litigation isroutine in nature and incidental to the conduct of our business.  We believe that no such litigation will havea material adverse effect on our financial condition, cash flows, or results ofoperations.

 

On August 21,2002, a lawsuit was filed against us in the State Court of Fulton County, Stateof Georgia by T.N.S. Mills, Inc. and Bowling Green Spinning Company in whichthe plaintiffs are claiming damages of approximately $830,000 related toan alleged oral guarantee of money owed to them by a third-party vendor.  On July 27, 2004 the court granted our motionfor summary judgment.

 

**ITEM 2. CHANGES IN SECURITIES:**

 

None

 

**ITEM 3. DEFAULTS UPON SENIORSECURITIES:**

 

None

 

**ITEM 4. SUBMISSION OF MATTERS TO A VOTEOF SECURITY HOLDERS:**

 

The Company held its Annual Meeting ofStockholders on May 14, 2004 (the “Annual Meeting”) for which proxies weresolicited pursuant to Regulation 14A of the Securities Exchange Act of 1934, asamended.

 

At the Annual Meeting, two Class I directorswere nominated for re-election, and the holders of Carter’s, Inc.’s commonstock elected both nominees as indicated by the following schedule of votescast:

 
| **Nominee**   | ** ** | **Total Votes  For** | ** ** | **Total Votes  Against** | ** ** | **Total  Abstentions** | ** ** | **Total Broker  Non-Votes** | ** ** |
|---------------|------------|----------------------|------------|--------------------------|------------|------------------------|------------|-----------------------------|------------|
| Ross M. Jones |       | 24,660,812           |       | 1,660,873                |       | —                 |       | —                      |       |
|          |       |                 |       |                     |       |                   |       |                        |       |
| David Pulver  |       | 26,129,923           |       | 191,762                  |       | —                 |       | —                      |       |

 

The Directorscontinuing to serve after the Annual Meeting were:  Class I directors - Ross M. Jones and DavidPulver, Class II directors - Bradley M. Bloom and Frederick J. Rowan, II, andClass III directors - Paul Fulton, John R. Welch, and Thomas Whiddon.

 

The holders ofCarter’s, Inc.’s common stock approved the Company’s 2003 Equity IncentivePlan.  A total of 23,856,557 votes werecast in favor, 1,582,577 votes were cast against, 5,585 votes were abstentions,and 876,966 votes were broker non-votes.

 

The holders ofCarter’s, Inc.’s common stock approved the Company’s Amended and RestatedAnnual Incentive Compensation Plan.   Atotal of 24,960,934 votes were cast in favor, 478,799 votes were cast against,4,986 votes were abstentions, and 876,966 votes were broker non-votes.

 

**ITEM 5. OTHER INFORMATION:**

 

None

 

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**ITEM 6. EXHIBITS AND REPORTS ON FORM8-K:**

 

(a) Exhibits:

 
| **Exhibit Number** | ** ** | **Description of Exhibits** |
|--------------------|------------|-----------------------------|
|               |       |                        |
| 31.1               |       |                        | Rule 13a-14(a)/15d-14(a) Certification |
|               |       |                        |   |
| 31.2               |       |                        | Rule 13a-14(a)/15d-14(a) Certification |
|               |       |                        |   |
| 31.3               |       |                        | Rule 13a-14(a)/15d-14(a) Certification |
|               |       |                        |   |
| 31.4               |       |                        | Rule 13a-14(a)/15d-14(a) Certification |
|               |       |                        |   |
| 32                 |       |                        | Section 1350 Certification |

 

(b) Reports onForm 8-K:

 

OnApril 27, 2004, Carter’s, Inc. filed a current report on Form 8-K with theSecurities and Exchange Commission. Under Item 12 of the report, we reported that on April 27, 2004,Carter’s, Inc. issued a press release announcing its financial results for thefirst quarter ended April 3, 2004.

 

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**SIGNATURES**

 

Pursuant tothe requirements of the Securities and Exchange Act of 1934, the Registrants haveduly caused this report to be signed on their behalf by the undersignedthereunto duly authorized.

 
|                                    | CARTER’S, INC.                                               |     |
|-----------------------------------------|-------------------------------------------------------------------|----------|
|                                    | THE WILLIAM CARTER COMPANY                                        |     |
|                                    |                                                              |     |
|                                    |                                                              |     |
| Date:   August  17, 2004 | /s/ FREDERICK J. ROWAN, II                                        |     |
|                                    | Frederick J. Rowan, II                                            |     |
|                                    | *Chairman of the Board of Directors and  Chief Executive Officer* |     |
|                                    |                                                              |     |
|                                    |                                                              |     |
| Date:   August  17, 2004 | /s/ MICHAEL D. CASEY                                              |     |
|                                    | Michael D. Casey                                                  | * * |
| * *                                | *Executive Vice President and  Chief Financial Officer*           | * * |

 

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