##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION   
 FORM 10-Q  
 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004 COMMISSION FILE NUMBER 333-62021   HOME INTERIORS & GIFTS, INC.  TEXAS
    
    75-0981828(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)1649 FRANKFORD ROAD WEST, CARROLLTON, TEXAS
    
    75007-4605(Address of principal executive offices)
    
    (Zip Code)
 (972) 695-1000
Registrants Telephone Number, Including Area Code Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [   ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes [   ] No [X] As of August 12, 2004, 15,240,218 shares of the Companys common stock, par
value $0.10 per share, were outstanding.




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HOME INTERIORS & GIFTS, INC. AND SUBSIDIARIES INDEX PAGE NO.PART I  FINANCIAL INFORMATIONItem 1. Unaudited Interim Consolidated Financial Statements:Consolidated Balance Sheets as of December 31, 2003 and June 30, 2004
    
    
    3Consolidated Statements of Operations and Comprehensive Income for the three months and
six months ended June 30, 2003 and 2004
    
    
    4Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2004
    
    
    5Notes to Unaudited Interim Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3. Quantitative and Qualitative Disclosure About Market Risk
    
    
    30Item 4. Controls and Procedures
    
    
    30PART II  OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    31Item 5. Other Information
    
    
    31Item 6. Exhibits and Reports on Form 8-K
    
    
    32Employment & Non-Compete AgreementExecutive Employment AgreementLetter of AgreementConfidential Separation AgreementCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
  2




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ITEM 1. UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS. HOME INTERIORS & GIFTS, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
As of December 31, 2003 and June 30, 2004 (Unaudited)December 31,
    
    June 30,2003
    
    2004(In thousands, exceptshare information)ASSETSCurrent assets:Cash
    
    $
    36,636
    
    
    $
    20,419Accounts receivable, net
    
    
    22,027
    
    
    
    27,053Inventories, net
    
    
    73,135
    
    
    
    83,181Deferred income tax asset
    
    
    6,006
    
    
    
    9,837Assets held for sale
    
    
    
    
    
    
    178Other current assets
    
    
    3,444
    
    
    
    8,083Total current assets
    
    
    141,248
    
    
    
    148,751Property, plant and equipment, net
    
    
    75,191
    
    
    
    68,969Debt issuance costs, net
    
    
    3,956
    
    
    
    10,960Goodwill
    
    
    14,519
    
    
    
    13,570Assets held for sale
    
    
    
    
    
    
    488Other assets, net
    
    
    1,009
    
    
    
    891Total assets
    
    $
    235,923
    
    
    $
    243,629LIABILITIES AND SHAREHOLDERS DEFICITCurrent liabilities:Book overdraft
    
    $
    4,913
    
    
    $
    4,953Accounts payable
    
    
    30,757
    
    
    
    24,042Accrued seminars and incentive awards
    
    
    15,592
    
    
    
    18,390Royalties payable to decorating consultants
    
    
    8,109
    
    
    
    4,871Accrued compensation
    
    
    4,796
    
    
    
    4,528Current maturity of related party note payable
    
    
    675
    
    
    
    675Current maturities of long-term debt and capital lease obligations
    
    
    10,099
    
    
    
    12,974Other current liabilities
    
    
    18,234
    
    
    
    22,515Total current liabilities
    
    
    93,175
    
    
    
    92,948Long-term related party note payable, net of current maturity
    
    
    687
    
    
    
    687Long-term debt and capital lease obligations, net of current maturities
    
    
    311,777
    
    
    
    458,736Deferred income tax liability
    
    
    2,586
    
    
    
    3,782Other liabilities
    
    
    19,080
    
    
    
    19,105Total liabilities
    
    
    427,305
    
    
    
    575,258Commitments
and contingencies (Note 12)Shareholders deficit:Preferred stock, par value $0.01 per share 10,000,000 shares
authorized 96,058.98 shares designated as cumulative 12.5% Senior
Convertible Preferred Stock at a liquidation value of $1,000 per
share, 96,058.98 shares issued and repurchased
    
    
    94,196
    
    
    
    Common stock, par value $0.10 per share, 75,000,000 shares
authorized, 15,240,218 shares issued and outstanding
    
    
    1,524
    
    
    
    1,524Additional paid-in capital
    
    
    185,036
    
    
    
    141,865Accumulated deficit
    
    
    (471,370
    )
    
    
    (474,253
    )Accumulated other comprehensive loss
    
    
    (768
    )
    
    
    (765
    )Total shareholders deficit
    
    
    (191,382
    )
    
    
    (331,629
    )Total liabilities and shareholders deficit
    
    $
    235,923
    
    
    $
    243,629
 The accompanying notes are an integral part of these consolidated financial statements. 3




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HOME INTERIORS & GIFTS, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
For the three months and six months ended June 30, 2003 and 2004
(In thousands)
(Unaudited) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Net sales
    
    $
    150,818
    
    
    $
    132,875
    
    
    $
    276,784
    
    
    $
    263,791Cost of goods sold
    
    
    65,885
    
    
    
    61,235
    
    
    
    120,267
    
    
    
    119,804Gross profit
    
    
    84,933
    
    
    
    71,640
    
    
    
    156,517
    
    
    
    143,987Selling, general and administrative:Selling
    
    
    26,270
    
    
    
    27,023
    
    
    
    46,771
    
    
    
    53,864Freight, warehouse and distribution
    
    
    18,269
    
    
    
    17,387
    
    
    
    33,891
    
    
    
    34,408General and administrative
    
    
    16,071
    
    
    
    17,998
    
    
    
    31,582
    
    
    
    35,678Loss on the disposition of assets
    
    
    289
    
    
    
    1,517
    
    
    
    293
    
    
    
    1,517Stock option expense
    
    
    1,291
    
    
    
    943
    
    
    
    2,215
    
    
    
    1,932Loss on debt refinancing
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,071Total selling, general and administrative
    
    
    62,190
    
    
    
    64,868
    
    
    
    114,752
    
    
    
    128,470Operating income
    
    
    22,743
    
    
    
    6,772
    
    
    
    41,765
    
    
    
    15,517Other income (expense):Interest income
    
    
    69
    
    
    
    89
    
    
    
    225
    
    
    
    159Interest expense
    
    
    (6,800
    )
    
    
    (9,183
    )
    
    
    (13,862
    )
    
    
    (16,187
    )Other income (expense), net
    
    
    396
    
    
    
    (457
    )
    
    
    303
    
    
    
    (380
    )Other income (expense), net
    
    
    (6,335
    )
    
    
    (9,551
    )
    
    
    (13,334
    )
    
    
    (16,408
    )Income loss from continuing operations
before income taxes
    
    
    16,408
    
    
    
    (2,779
    )
    
    
    28,431
    
    
    
    (891
    )Income tax provision (benefit)
    
    
    5,978
    
    
    
    (2,259
    )
    
    
    10,451
    
    
    
    (1,716
    )Income (loss) from continuing operations
    
    
    10,430
    
    
    
    (520
    )
    
    
    17,980
    
    
    
    825Discontinued operations (Note 6):Loss from operations of discontinued
ceramics manufacturing
    
    
    635
    
    
    
    3,261
    
    
    
    1,080
    
    
    
    3,708Income tax benefit
    
    
    58
    
    
    
    
    
    
    
    186
    
    
    
    Discontinued operations loss, net of tax
    
    
    577
    
    
    
    3,261
    
    
    
    894
    
    
    
    3,708Net income (loss)
    
    
    9,853
    
    
    
    (3,781
    )
    
    
    17,086
    
    
    
    (2,883
    )Other comprehensive income (loss):Cumulative translation adjustment
    
    
    345
    
    
    
    (27
    )
    
    
    343
    
    
    
    3Other comprehensive income (loss)
    
    
    345
    
    
    
    (27
    )
    
    
    343
    
    
    
    3Comprehensive income (loss)
    
    $
    10,198
    
    
    $
    (3,808
    )
    
    $
    17,429
    
    
    $
    (2,880
    )
 The accompanying notes are an integral part of these consolidated financial statements. 4




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HOME INTERIORS & GIFTS, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Six Months Ended June 30, 2003 and 2004
(In Thousands)
(Unaudited) Six Months EndedJune 30,2003
    
    2004Cash flows from operating activities:Net income (loss)
    
    $
    17,086
    
    
    $
    (2,883
    )Adjustments to reconcile net income to net cash used in operating activities:Depreciation and amortization
    
    
    7,662
    
    
    
    7,502Impairment of goodwill
    
    
    
    
    
    
    1,060Impairment of property, plant, and equipment
    
    
    
    
    
    
    1,409Amortization of debt issuance costs
    
    
    555
    
    
    
    1,051Provision for doubtful accounts
    
    
    1,427
    
    
    
    1,625Provision for losses on inventories
    
    
    (2,723
    )
    
    
    841Loss on debt refinancing
    
    
    
    
    
    
    1,071Loss on disposition of assets
    
    
    293
    
    
    
    1,517Stock option expense
    
    
    2,215
    
    
    
    1,932Deferred tax benefit
    
    
    (1,963
    )
    
    
    (714
    )Changes in assets and liabilities:Accounts receivable
    
    
    (13,805
    )
    
    
    (6,651
    )Inventories
    
    
    (29,239
    )
    
    
    (11,110
    )Other current assets
    
    
    (1,507
    )
    
    
    (6,561
    )Other assets
    
    
    (137
    )
    
    
    150Accounts payable
    
    
    12,249
    
    
    
    (6,562
    )Related party payable
    
    
    
    
    
    
    (661
    )Income taxes payable
    
    
    6,328
    
    
    
    (2,934
    )Other current liabilities
    
    
    (10,146
    )
    
    
    7,095Total adjustments
    
    
    (28,791
    )
    
    
    (9,940
    )Net cash used in operating activities
    
    
    (11,705
    )
    
    
    (12,823
    )Cash flows from investing activities:Purchases of property, plant and equipment
    
    
    (8,546
    )
    
    
    (3,036
    )Business acquisitions, net of cash acquired
    
    
    (12,430
    )
    
    
    Proceeds from the sale of property, plant and equipment
    
    
    23
    
    
    
    4Net cash used in investing activities
    
    
    (20,953
    )
    
    
    (3,032
    )Cash flows from financing activities:Book overdraft
    
    
    (804
    )
    
    
    40Payments of principal under capital lease obligations
    
    
    (1,165
    )
    
    
    (799
    )Proceeds from borrowings under New Senior Credit Facility
    
    
    
    
    
    
    320,000Payments of principal under Senior Credit Facility
    
    
    (14,187
    )
    
    
    (168,682
    )Payments of principal under New Senior Credit Facility
    
    
    
    
    
    
    (2,500
    )Debt issuance costs
    
    
    
    
    
    
    (9,125
    )Payment of principal of other bank debt
    
    
    (750
    )
    
    
    Preferred stock repurchase costs
    
    
    
    
    
    
    (299
    )Payment of preferred stock repurchase
    
    
    
    
    
    
    (109,459
    )Payment of preferred stock dividends
    
    
    
    
    
    
    (29,541
    )Net cash used in financing activities
    
    
    (16,906
    )
    
    
    (365
    )Effect of cumulative translation adjustment
    
    
    343
    
    
    
    3Net decrease in cash
    
    
    (49,221
    )
    
    
    (16,217
    )Cash at beginning of year
    
    
    68,111
    
    
    
    36,636Cash at end of period
    
    $
    18,890
    
    
    $
    20,419
 The accompanying notes are an integral part of these consolidated financial statements. 5




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HOME INTERIORS & GIFTS, INC. AND SUBSIDIARIES 
 NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Background Home Interiors & Gifts, Inc. (the Company) is a fully integrated
manufacturer and distributor of home decorative accessories. The Company
believes it is the largest direct seller of home decorative accessories in the
United States, as measured by net sales. The Companys products include, but
are not limited to, framed artwork and mirrors, candles and candle accessories,
plaques, figurines, planters, artificial floral arrangements, wall shelves,
sconces, small furniture, and tableware (the Products). The Company primarily
sells the Products through a direct selling channel of non-employee,
independent contractor sales representatives (Decorating Consultants) who
resell the Products primarily through one-on-one sales, brochure sales and
through the party-plan method of conducting in-home presentations to
potential customers. The Company has approximately 95,600 active Decorating
Consultants located in the United States, Mexico, Canada and Puerto Rico. The Company has been located in Dallas, Texas since its inception in 1957.
Currently the majority of the Companys outstanding common stock of record is
owned by affiliates of Hicks, Muse, Tate & Furst Incorporated, a Dallas-based
private investment firm (Hicks Muse). The Company purchases its Products from a select number of independent
suppliers as well as from its wholly owned subsidiaries. During the first six
months of 2004, approximately 53% of the dollar volume of Products purchased
for the direct selling channel of the Company was purchased from, and
manufactured by, the Companys subsidiaries. In addition to the Products sold
to the Company for the direct selling channel, certain subsidiaries have a
growing presence in the wholesale supply market. 2. Significant Accounting Policies These consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries. All significant intercompany
balances and transactions have been eliminated in the consolidation. The
Company records sales and related expenses on a weekly basis ending on each
Saturday. Each quarter consists of thirteen weeks. The final day of the
quarters ended June 30, 2003 and 2004 included in the accompanying unaudited
consolidated financial information was June 28, 2003 and July 3, 2004,
respectively. The consolidated financial information as of June 30, 2004 and for the
three months and six months ended June 30, 2003 and 2004 is unaudited. In the
opinion of management, the accompanying unaudited consolidated financial
information and related notes thereto contain all adjustments, consisting only
of normal, recurring adjustments, necessary to present fairly the Companys
consolidated financial position as of June 30, 2004 and December 31, 2003, its
operating results and comprehensive income for the three months and six months
ended June 30, 2003 and 2004, and its cash flows for the six months ended June
30, 2003 and 2004. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been omitted pursuant to the rules and regulations
of the Securities and Exchange Commission (the SEC). The results of
operations for the periods presented are not necessarily indicative of the
results to be expected for the full year. These unaudited interim consolidated financial statements and notes
thereto should be read in conjunction with the Companys audited consolidated
financial statements and notes thereto included in the Companys Form 10-K for
the year ended December 31, 2003 as filed with the SEC. Reclassifications Certain reclassifications have been made to prior period balances to
conform with the current year presentation. The Company has reclassified the operating losses attributed to the
discontinued operations of the ceramics manufacturing plant to losses from
discontinued operations in the statement of consolidated operations and 6




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comprehensive income for the three and six months ended June 30, 2003 and
2004. The effect of this reclassification increased operating income $.6
million and $1.1 million for the three months and six months ended June 30,
2003. This reclassification had no impact on net income for the three months
and six months ended June 30, 2003. Stock-based Compensations Plans The Company has adopted three stock option plans. For Decorating
Consultants and independent contractors, the Company has adopted the
Independent Contractor Stock Option Plan and accounts for options issued
under the Independent Contractor Stock Option Plan in accordance with Statement
of Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation (SFAS No. 123). For key employees, the Company has adopted the
1998 Key Employee Stock Option Plan and the 2002 Key Employee Stock Option
Plan. The Company accounts for the options issued under the 1998 Key Employee
Stock Option Plan and the 2002 Key Employee Stock Option Plan in accordance
with the Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees (APB No. 25), as allowed by FAS 123. Compensation Charge SFAS No. 123 establishes a fair value basis of accounting for stock-based
compensation plans. The effects of applying SFAS No. 123 as shown below are not
indicative of future amounts. Had the compensation cost for the Companys 1998
Key Employee Stock Option Plan and 2002 Key Employee Stock Option Plan been
determined consistent with SFAS No. 123, the Companys compensation cost and
net income for the three months and six months ended June 30, 2003 and 2004
would approximate (in thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Net income (loss), as reported
    
    $
    9,853
    
    
    $
    (3,781
    )
    
    $
    17,086
    
    
    $
    (2,883
    )Add: Stock-based employee
compensation expense included
in reported net income, net
of related tax effects
    
    
    495
    
    
    
    446
    
    
    
    991
    
    
    
    937Deduct: Stock-based employee
compensation expense
determined under fair value
based method for all awards,
net of related tax effects
    
    
    (682
    )
    
    
    (507
    )
    
    
    (1,263
    )
    
    
    (1,027
    )Pro forma net income (loss)
    
    $
    9,666
    
    
    $
    (3,842
    )
    
    $
    16,814
    
    
    $
    (2,973
    )
 3. Inventories, Net Inventories, net, consisted of the following as of December 31, 2003 and
June 30, 2004 (in thousands): December 31,
    
    June 30,2003
    
    2004Raw materials
    
    $
    9,364
    
    
    $
    11,268Work in process
    
    
    2,458
    
    
    
    2,570Finished goods
    
    
    66,212
    
    
    
    74,33578,034
    
    
    
    88,173Inventory allowance
    
    
    (4,899
    )
    
    
    (4,992
    )$
    73,135
    
    
    $
    83,181
 7




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4. Other Current Liabilities Other current liabilities consisted of the following as of December 31,
2003 and June 30, 2004 (in thousands): December 31,
    
    June 30,2003
    
    2004Interest
    
    $
    1,258
    
    
    $
    1,414Accrued employee benefits
    
    
    4,443
    
    
    
    3,817Income taxes payable
    
    
    2,934
    
    
    
    Sales taxes
    
    
    3,498
    
    
    
    4,779Other taxes
    
    
    1,535
    
    
    
    1,343Deferred revenue
    
    
    2,033
    
    
    
    7,989Related parties
    
    
    600
    
    
    
    83Other
    
    
    1,933
    
    
    
    3,090$
    18,234
    
    
    $
    22,515
 5. Adoption of New Accounting Standards In April 2004, the Financial Accounting Standards Board (FASB), issued
Staff Position Statement of Financial Accounting Standards No. 129-1,
Disclosure Requirements under FASB Statement No. 129, Disclosure of
Information about Capital Structure, Relating to Contingently Convertible
Securities (FSP FAS 129-1). FSP FAS 129-1 provides interpretation guidance
regarding the disclosure provisions of FASB Statement No. 129 as it applies to
contingently convertible securities and the potential dilutive effects on
earnings per share. FSP FAS 129-1 is effective as of April 9, 2004 and applies
to all existing and newly created securities. The Company adopted FSP FAS 129-1
on April 9, 2004 and there was no financial accounting impact associated with
its adoption. 6. Discontinued Operations In
the first quarter of 2003 the Company acquired 100% of the assets of
Ceramica y Vidrio de Nuevo Leon, S.A. de C.V., Maquiladora Produr,
S.A. de C.V., and Industrias Tromex Corporation, S.A. de C.V.
(collectively Produr). Produr manufactured glass,
ceramics, and metal products and is located in Monterrey, Mexico. In
the second quarter of 2004 the Company made the decision to
discontinue the manufacture of ceramics products and, also, to close
the glass manufacturing plant. The Company has accounted for the
shutdown of the manufacturing efforts of ceramics products as
discontinued operations in the consolidated statement of operations
and comprehensive income for the period ended June 30, 2004, as
discussed below. The costs incurred related to the shutdown of the
glass manufacturing facility are reflected in continuing operations
in the consolidated statement of operations and comprehensive income
for the period ended June 30, 2004, since the Company will continue
to source glass products from non-affiliated vendors and distribute
glass products to non-affiliated retailers, (Note 7 Assets Held for
Sale). On April 28, 2004, the Company discontinued the manufacture of ceramics
products that were produced in its Mexico manufacturing facility due to the
loss of a major retail customer to an overseas manufacturer. The Company has
no plans to manufacture ceramics products in the future. The Company has
incurred approximately $0.6 million in severance costs, $0.1 million in
contract termination costs, $1.3 million in impairment of property plant and
equipment, and $1.1 million in impairment of goodwill related to the shut-down
and disposal activity. The remaining assets related to the manufacture of
ceramics products have been classified as assets held for sale and the Company
anticipates disposing of all assets within one year. The operations and cash flows of the ceramics manufacturing operation have
been eliminated from the Companys ongoing operations as a result of the
shut-down, and the Company does not have any continued involvement in the
manufacture of ceramics products. The results of operations of ceramics
manufacturing have been classified as discontinued operations, and information
presented for all periods reflects the new classification. The operations of
ceramics manufacturing were previously reported in the Companys Domistyle
operating segment. Components of amounts reflected as loss on discontinued
operations in the Companys consolidated statements of operations and
comprehensive income and statement of financial position are presented in the
following table (in thousands): 8




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Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Net sales
    
    $
    431
    
    
    $
    392
    
    
    $
    600
    
    
    $
    828Cost of goods sold
    
    
    742
    
    
    
    1,076
    
    
    
    1,251
    
    
    
    1,776Gross profit
    
    
    (311
    )
    
    
    (684
    )
    
    
    (651
    )
    
    
    (948
    )Selling, general and administrative:General and administrative
    
    
    330
    
    
    
    2,454
    
    
    
    459
    
    
    
    2,632Total selling, general and administrative
    
    
    330
    
    
    
    2,454
    
    
    
    459
    
    
    
    2,632Operating loss
    
    
    (641
    )
    
    
    (3,138
    )
    
    
    (1,110
    )
    
    
    (3,580
    )Other income (expense):Interest expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2
    )Other income (expense), net
    
    
    6
    
    
    
    (123
    )
    
    
    30
    
    
    
    (126
    )Other income (expense), net
    
    
    6
    
    
    
    (123
    )
    
    
    30
    
    
    
    (128
    )Loss before income taxes
    
    
    (635
    )
    
    
    (3,261
    )
    
    
    (1,080
    )
    
    
    (3,708
    )Income tax benefit
    
    
    58
    
    
    
    
    
    
    
    186
    
    
    
    Loss on discontinued operations, net of tax
    
    $
    (577
    )
    
    $
    (3,261
    )
    
    $
    (894
    )
    
    $
    (3,708
    )
 (Unaudited)June 30, 2004Balance sheet data:Current assets held for sale
    
    $
    3Long term assets held for sale
    
    $
    206
 7. Assets Held for Sale Assets classified as held for sale include the remaining assets related to
the discontinuation of manufacture of ceramics products (Note 6 Discontinued
Operations) and the remaining assets related to the manufacture of glass
products. In May 2004, the Company made the decision to cease the manufacture of
glass products, and in June 2004 the glass manufacturing plant was shut down.
The Company has incurred approximately $0.9 million in impairment of property,
plant and equipment related to the glass plant closure. The remaining assets
of the glass manufacturing plant have been classified as assets held for sale
in the consolidated statement of financial position, $0.2 million current
assets held for sale and $0.2 million long term assets held for sale. The
Company anticipates disposing of all assets within one year. 8. Refinancing of Senior Credit Facility On March 31, 2004, the Company entered into a senior credit facility, New
Senior Credit Facility, with Bear Stearns Corporate Lending Inc., as
syndication agent, JPMorgan Chase Bank, as administrative agent, and the
several lenders from time to time parties thereto, pursuant to which the
Company, among other things, refinanced loans outstanding under the Companys
existing credit facility. The New Senior Credit Facility provides a seven-year
term loan facility of up to $320.0 million, Term Loans, and a $50.0 million
five-year revolving credit facility, Revolving Loans. 9




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##### Table of Contents



On March 31, 2004, $320.0 million in proceeds received from the Term Loans
were used to complete the following transactions:  
    
    For an aggregate purchase price of $139.0 million, the Company
repurchased all of the Companys outstanding shares of its 12.5%
Senior Convertible Preferred Stock, pursuant to a Stock Purchase
Agreement, dated March 31, 2004, among the Company and certain
affiliates of the Companys controlling stockholders the Preferred
Stock Repurchase.
    
    $169.1 million of the proceeds were used to pay off the existing
credit facility which included an outstanding debt balance, related
partial year interest, commitment fees, and outstanding letter of
credit fees.
    
    $9.4 million of the proceeds were used to pay legal and advisory
fees associated with the Preferred Stock Repurchase and to pay off of
the existing credit facility, and New Senior Credit Facility debt
issuance costs. There were no amounts drawn under the Revolving Loans and the remaining
Term Loan proceeds of approximately $2.5 million were used for general working
capital purposes. As a result of the existing credit facility refinancing, the Company
recognized a $1.1 million loss related to a $0.4 million write-off of
unamortized debt issuance costs and $0.7 million of legal and advisory costs
for the six month period ended June 30, 2004. The Company also incurred debt
issuance costs related to the New Senior Credit Facility of $8.4 million that
were deferred. As a result of the Preferred Stock Repurchase, the Company
recognized a $45.1 million reduction in additional paid-in-capital related to
$29.5 million preferred stock dividends paid, $15.3 million premium paid in
excess of the liquidation value of the preferred stock, and $0.3 million of
legal and advisory fees. Borrowings under the New Senior Credit Facility require quarterly
principal and interest payments. The term loan facility matures on March 31,
2011 and the revolving loan facility matures on March 31, 2009 provided that in
the event that the senior subordinated notes (Notes) are not refinanced in
whole on or prior to December 1, 2007 through the issuance of refinancing
securities with a maturity no less than six months after March 31, 2011,
incremental term loans, or an initial public offering, then all Term Loans
outstanding will be due and payable and the revolving credit facility will
terminate on that date. Accordingly, the Company is amortizing its debt
issuance costs over the period from March 31, 2004 through December 1, 2007.
The Company may, at its option, prepay the Term Loans and Revolving Loans
without premium or penalty provided that in certain circumstances prepayment of
the Term Loans on or prior to the first anniversary of the closing date of the
New Senior Credit Facility must be accompanied by a 1% prepayment premium.
Additionally, the Company may reduce or eliminate its revolving loan commitment
prior to maturity. The New Senior Credit Facility is guaranteed
unconditionally on a senior basis by the Companys wholly owned domestic
subsidiaries and is collateralized by a lien on substantially all assets of the
Company and its wholly owned domestic subsidiaries. There are no material
restrictions on the Companys ability to obtain funds from its wholly owned
subsidiaries by dividend or otherwise. The Term Loans under the New Senior Credit Facility bear interest, at the
Companys election, at either LIBOR plus an applicable margin or the Alternate
Base Rate plus an applicable margin. The Alternate Base Rate is the higher of
the prime rate of JPMorgan Chase Bank, the Base CD rate in effect plus 1%, or
the federal funds effective rate plus 0.5%. For the Revolving Loans the
applicable LIBOR margin and Alternate Base Rate margin are subject to
adjustments, upwards or downwards after December 31, 2004, based upon the
leverage ratio as defined by the New Senior Credit Agreement. The interest
rates on all borrowings outstanding under the New Senior Credit Facility were
based on LIBOR as of June 30, 2004. As of June 30, 2004, term borrowings
outstanding totaled $317.5 million. The weighted-average interest rate on the
Term Loan borrowings outstanding at June 30, 2004 was 5.41%. The Revolving Loans are subject to a commitment fee based on the undrawn
portion of the Revolving Loans. The commitment fee is eligible for certain
performance pricing step-downs and was 0.5% per annum as of June 30, 2004.
Outstanding letters of credit totaled $4.2 million as of June 30, 2004. 10




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##### Table of Contents



The terms of the Notes and New Senior Credit Facility include significant
operating and financial restrictions, such as limits on the Companys ability
to incur indebtedness, create liens, sell assets, engage in mergers,
acquisitions or consolidations, make investments and pay dividends. In
addition, under the New Senior Credit Facility, the Company is required to
comply with specified financial ratios and tests, an interest coverage ratio,
maximum leverage ratio, and maximum capital expenditures as defined per the New
Senior Credit Facility agreement. A summary of long-term debt obligations under the New Senior Credit
Facility as of June 30, 2004 is as follows (in thousands): Term Loans, interest at LIBOR plus an applicable margin (5.41%)
    
    $
    317,500Less current maturities
    
    
    (11,250
    )$
    306,250
 The following table represents a summary of the maturities of Term Loans under
the New Senior Credit Facility as of June 30, 2004 (in thousands): 2004
    
    $
    5,0002005
    
    
    13,7502006
    
    
    15,0002007
    
    
    283,750$
    317,500
 9. Income Tax Benefit The income tax benefit for the three and six month periods ended June 30,
2004 includes a $1.6 million benefit associated with a deduction the Company
will take in its 2004 U.S. tax return for the closure of a subsidiary in
Mexico. 10. Segment Reporting The Companys reportable segments are based upon functional lines of
business as follows:  
    
    Direct Selling Domestic  direct seller of home decorative
accessories in the United States;
    
    Direct Selling International  direct seller of home decorative
accessories in Mexico, Canada and Puerto Rico; and
    
    Domistyle  wholesale supply operation that manufactures, imports,
and distributes candles, framed artwork, mirrors, various types of
molded plastic and metal products for affiliates and other
non-affiliated resellers. The Company evaluates the performance of its segments and allocates
resources to them based on earnings before interest, unrealized gain on
derivatives, taxes, the effects of SAB 101, discontinued operations,
depreciation and amortization, reorganization costs, non-cash expense for stock
options, losses on debt refinancing, impairment of goodwill, and losses on
disposition of assets (defined as Modified EBITDA). Prior years Modified
EBITDA has been recalculated for comparative purposes. The accounting
principles of the segments are the same as those described in Note 2. Segment
data includes intersegment sales and intercompany net receivable balances.
Eliminations consist primarily of intersegment sales between the Domistyle
segment and the direct selling segments, as well as the elimination of the
investment in each subsidiary for consolidation purposes. The table below
presents information about reportable segments used by the Companys chief
operating decision makers as of and for the three months and six months ended
June 30, 2003 and 2004 (in thousands): 11




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##### Table of Contents



Direct
    
    DirectSelling
    
    SellingThree months ended June 30,
    
    Domestic
    
    International
    
    Domistyle
    
    Eliminations
    
    Consolidated2003Net sales to non-affiliates
    
    $
    131,535
    
    
    $
    14,351
    
    
    $
    4,932
    
    
    $
    
    
    
    $
    150,818Net sales to affiliates
    
    
    13,581
    
    
    
    
    
    
    
    36,923
    
    
    
    (50,504
    )
    
    
    Modified EBITDA
    
    
    16,996
    
    
    
    2,222
    
    
    
    11,229
    
    
    
    (1,857
    )
    
    
    28,5902004Net sales to non-affiliates
    
    $
    110,751
    
    
    $
    16,122
    
    
    $
    6,002
    
    
    $
    
    
    
    $
    132,875Net sales to affiliates
    
    
    8,518
    
    
    
    
    
    
    
    33,272
    
    
    
    (41,790
    )
    
    
    Modified EBITDA
    
    
    6,863
    
    
    
    2,112
    
    
    
    10,566
    
    
    
    (514
    )
    
    
    19,027
 Direct
    
    DirectSelling
    
    SellingSix months ended June 30,
    
    Domestic
    
    International
    
    Domistyle
    
    Eliminations
    
    Consolidated2003Net sales to non-affiliates
    
    $
    241,453
    
    
    $
    24,444
    
    
    $
    10,887
    
    
    $
    
    
    
    $
    276,784Net sales to affiliates
    
    
    18,222
    
    
    
    
    
    
    
    70,158
    
    
    
    (88,380
    )
    
    
    Modified EBITDA
    
    
    32,637
    
    
    
    2,685
    
    
    
    23,105
    
    
    
    (2,230
    )
    
    
    56,197Total assets
    
    
    225,119
    
    
    
    8,001
    
    
    
    85,812
    
    
    
    (74,340
    )
    
    
    244,592Goodwill
    
    
    
    
    
    
    
    
    
    
    12,695
    
    
    
    
    
    
    
    12,695Capital expenditures
    
    
    4,890
    
    
    
    75
    
    
    
    3,581
    
    
    
    
    
    
    
    8,5462004Net sales to non-affiliates
    
    $
    219,280
    
    
    $
    30,382
    
    
    $
    14,129
    
    
    $
    
    
    
    $
    263,791Net sales to affiliates
    
    
    15,216
    
    
    
    
    
    
    
    68,459
    
    
    
    (83,675
    )
    
    
    Modified EBITDA
    
    
    16,598
    
    
    
    3,301
    
    
    
    19,890
    
    
    
    (1,549
    )
    
    
    38,240Total assets
    
    
    219,077
    
    
    
    16,119
    
    
    
    82,588
    
    
    
    (74,155
    )
    
    
    243,629Goodwill
    
    
    
    
    
    
    
    
    
    
    13,570
    
    
    
    
    
    
    
    13,570Capital expenditures
    
    
    1,343
    
    
    
    537
    
    
    
    1,156
    
    
    
    
    
    
    
    3,036
 The following table represents a reconciliation of net income to
consolidated Modified EBITDA for the three months and six months ended June 30,
2003 and 2004 (in thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2003
    
    2004
    
    2003
    
    2004Net income (loss)
    
    $
    9,853
    
    
    $
    (3,781
    )
    
    $
    17,086
    
    
    $
    (2,883
    )Effect of SAB 101
    
    
    (708
    )
    
    
    (602
    )
    
    
    2,862
    
    
    
    2,267Discontinued operations, net of tax
    
    
    577
    
    
    
    3,261
    
    
    
    894
    
    
    
    3,708Interest income
    
    
    (69
    )
    
    
    (89
    )
    
    
    (225
    )
    
    
    (159
    )Interest expense
    
    
    6,800
    
    
    
    9,183
    
    
    
    13,862
    
    
    
    16,187Unrealized gain on derivatives
    
    
    
    
    
    
    (89
    )
    
    
    
    
    
    
    (89
    )Income tax provision (benefit)
    
    
    5,978
    
    
    
    (2,259
    )
    
    
    10,451
    
    
    
    (1,716
    )Depreciation and amortization
    
    
    3,960
    
    
    
    3,566
    
    
    
    7,602
    
    
    
    7,421Stock option expense
    
    
    1,291
    
    
    
    943
    
    
    
    2,215
    
    
    
    1,932Loss on debt refinancing
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,071Reorganization costs
    
    
    619
    
    
    
    7,377
    
    
    
    1,157
    
    
    
    8,984Loss on disposition of assets
    
    
    289
    
    
    
    1,517
    
    
    
    293
    
    
    
    1,517Modified EBITDA
    
    $
    28,590
    
    
    $
    19,027
    
    
    $
    56,197
    
    
    $
    38,240
 11. Guarantor Financial Data Dallas Woodcraft Company, LP, DWC GP, Inc., GIA, Inc., Homco, Inc., Spring
Valley Scents, Inc., Laredo Candle Company, L.P., Domistyle, Inc., EM Boehm,
Inc., Home Interiors de Puerto Rico, Inc. and HIG Investments, Inc.
(collectively, the Guarantors) unconditionally, on a joint and several basis,
guarantee the Companys (Borrower) payment and performance of its obligation
under the New Senior Credit Facility 12




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##### Table of Contents



agreement and the Borrowers 10 1/8% Senior Subordinated Notes due 2008 in
the amount of $149.1 million (the Notes). The Companys other subsidiaries,
Home Interiors de Mexico, S. de R.L. de C.V., Home Interiors Services de
Mexico, S.A. de C.V., HI Ceramics, S.A. de C.V., HI Metals, S.A. de C.V., HI
Glass, S.A. de C.V., HI Trading Mexicana, S.A. de C.V., and Home Interiors &
Gifts of Canada, Inc. (collectively, the Non-Guarantors) have not guaranteed
the New Senior Credit Facility or the Notes. Guarantor and Non-Guarantor
financial statements on an individual basis are not significant and have been
omitted. Accordingly, the following table presents financial information of the
Guarantors and Non-Guarantors on a consolidating basis (in thousands): 13




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##### Table of Contents



Condensed Consolidating Statement of Operations and Comprehensive Income (Loss)
For the Three Months Ended June 30, 2003 Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    147,196
    
    
    $
    40,394
    
    
    $
    14,525
    
    
    $
    (51,297
    )
    
    $
    150,818Cost of goods sold
    
    
    78,682
    
    
    
    26,483
    
    
    
    10,228
    
    
    
    (49,508
    )
    
    
    65,885Gross profit
    
    
    68,514
    
    
    
    13,911
    
    
    
    4,297
    
    
    
    (1,789
    )
    
    
    84,933Total selling, general and administrative
    
    
    54,889
    
    
    
    2,997
    
    
    
    4,304
    
    
    
    
    
    
    
    62,190Operating income (loss)
    
    
    13,625
    
    
    
    10,914
    
    
    
    (7
    )
    
    
    (1,789
    )
    
    
    22,743Other income (expense), net
    
    
    (6,359
    )
    
    
    105
    
    
    
    (92
    )
    
    
    11
    
    
    
    (6,335
    )Income (loss) before income taxes
    
    
    7,266
    
    
    
    11,019
    
    
    
    (99
    )
    
    
    (1,778
    )
    
    
    16,408Income tax benefit (provision)
    
    
    (2,055
    )
    
    
    (4,043
    )
    
    
    120
    
    
    
    
    
    
    
    (5,978
    )Equity in income (loss) of affiliated
companies, net of tax
    
    
    6,500
    
    
    
    (1,345
    )
    
    
    
    
    
    
    (5,155
    )
    
    
    Net income (loss) from continuing
operations
    
    
    11,711
    
    
    
    5,631
    
    
    
    21
    
    
    
    (6,933
    )
    
    
    10,430Discontinued operations loss, net of tax
(Note 6)
    
    
    
    
    
    
    
    
    
    
    577
    
    
    
    
    
    
    
    577Net income (loss)
    
    
    11,711
    
    
    
    5,631
    
    
    
    (556
    )
    
    
    (6,933
    )
    
    
    9,853Other comprehensive income (loss)
    
    
    (7
    )
    
    
    
    
    
    
    352
    
    
    
    
    
    
    
    345Comprehensive income (loss)
    
    $
    11,704
    
    
    $
    5,631
    
    
    $
    (204
    )
    
    $
    (6,933
    )
    
    $
    10,198
 Condensed Consolidating Statement of Operations and Comprehensive Income (Loss)
For the Six Months Ended June 30, 2003 Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    262,970
    
    
    $
    78,968
    
    
    $
    24,277
    
    
    $
    (89,431
    )
    
    $
    276,784Cost of goods sold
    
    
    139,366
    
    
    
    51,484
    
    
    
    16,681
    
    
    
    (87,264
    )
    
    
    120,267Gross profit
    
    
    123,604
    
    
    
    27,484
    
    
    
    7,596
    
    
    
    (2,167
    )
    
    
    156,517Total selling, general and administrative
    
    
    102,010
    
    
    
    5,194
    
    
    
    7,548
    
    
    
    
    
    
    
    114,752Operating income (loss)
    
    
    21,594
    
    
    
    22,290
    
    
    
    48
    
    
    
    (2,167
    )
    
    
    41,765Other income (expense), net
    
    
    (13,314
    )
    
    
    191
    
    
    
    (232
    )
    
    
    21
    
    
    
    (13,334
    )Income (loss) before income taxes
    
    
    8,280
    
    
    
    22,481
    
    
    
    (184
    )
    
    
    (2,146
    )
    
    
    28,431Income tax benefit (provision)
    
    
    (2,620
    )
    
    
    (8,006
    )
    
    
    175
    
    
    
    
    
    
    
    (10,451
    )Equity in income (loss) of affiliated
companies, net of tax
    
    
    13,656
    
    
    
    (1,754
    )
    
    
    
    
    
    
    (11,902
    )
    
    
    Net income (loss) from continuing
operations
    
    
    19,316
    
    
    
    12,721
    
    
    
    (9
    )
    
    
    (14,048
    )
    
    
    17,980Discontinued operations loss, net of tax
(Note 6)
    
    
    
    
    
    
    
    
    
    
    894
    
    
    
    
    
    
    
    894Net income (loss)
    
    
    19,316
    
    
    
    12,721
    
    
    
    (903
    )
    
    
    (14,048
    )
    
    
    17,086Other comprehensive income (loss)
    
    
    (10
    )
    
    
    
    
    
    
    353
    
    
    
    
    
    
    
    343Comprehensive income (loss)
    
    $
    19,306
    
    
    $
    12,721
    
    
    $
    (550
    )
    
    $
    (14,048
    )
    
    $
    17,429
 14




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##### Table of Contents



Condensed Consolidating Statement of Operations and Comprehensive Income (Loss)
For the Three Months Ended June 30, 2004 Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    121,352
    
    
    $
    37,857
    
    
    $
    16,351
    
    
    $
    (42,685
    )
    
    $
    132,875Cost of goods sold
    
    
    65,075
    
    
    
    25,897
    
    
    
    12,639
    
    
    
    (42,376
    )
    
    
    61,235Gross profit
    
    
    56,277
    
    
    
    11,960
    
    
    
    3,712
    
    
    
    (309
    )
    
    
    71,640Total selling, general and administrative
    
    
    53,711
    
    
    
    3,072
    
    
    
    8,085
    
    
    
    
    
    
    
    64,868Operating income (loss)
    
    
    2,566
    
    
    
    8,888
    
    
    
    (4,373
    )
    
    
    (309
    )
    
    
    6,772Other income (expense), net
    
    
    (8,928
    )
    
    
    257
    
    
    
    (675
    )
    
    
    (205
    )
    
    
    (9,551
    )Income (loss) before income taxes
    
    
    (6,362
    )
    
    
    9,145
    
    
    
    (5,048
    )
    
    
    (514
    )
    
    
    (2,779
    )Income tax benefit (provision)
    
    
    4,323
    
    
    
    (1,674
    )
    
    
    (394
    )
    
    
    4
    
    
    
    2,259Equity in income (loss) of affiliated
companies, net of tax
    
    
    (1,229
    )
    
    
    (9,420
    )
    
    
    
    
    
    
    10,649
    
    
    
    Net income (loss) from continuing
operations
    
    
    (3,268
    )
    
    
    (1,949
    )
    
    
    (5,442
    )
    
    
    10,139
    
    
    
    (520
    )Discontinued operations loss, net of tax
(Note 6)
    
    
    
    
    
    
    
    
    
    
    3,261
    
    
    
    
    
    

    
    3,261Net income (loss)
    
    
    (3,268
    )
    
    
    (1,949
    )
    
    
    (8,703
    )
    
    
    10,139
    
    
    
    (3,781
    )Other comprehensive income (loss)
    
    
    1
    
    
    
    
    
    
    
    (28
    )
    
    
    
    
    
    
    (27
    )Comprehensive income (loss)
    
    $
    (3,267
    )
    
    $
    (1,949
    )
    
    $
    (8,731
    )
    
    $
    10,139
    
    
    $
    (3,808
    )Condensed Consolidating Statement of Operations and Comprehensive Income (Loss)
For the Six Months Ended June 30, 2004Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Eliminations
    
    ConsolidatedNet sales
    
    $
    238,568
    
    
    $
    79,353
    
    
    $
    32,179
    
    
    $
    (86,309
    )
    
    $
    263,791Cost of goods sold
    
    
    126,969
    
    
    
    53,812
    
    
    
    24,076
    
    
    
    (85,053
    )
    
    
    119,804Gross profit
    
    
    111,599
    
    
    
    25,541
    
    
    
    8,103
    
    
    
    (1,256
    )
    
    
    143,987Total selling, general and administrative
    
    
    108,179
    
    
    
    6,671
    
    
    
    13,620
    
    
    
    
    
    
    
    128,470Operating income (loss)
    
    
    3,420
    
    
    
    18,870
    
    
    
    (5,517
    )
    
    
    (1,256
    )
    
    
    15,517Other income (expense), net
    
    
    (15,712
    )
    
    
    390
    
    
    
    (793
    )
    
    
    (293
    )
    
    
    (16,408
    )Income (loss) before income taxes
    
    
    (12,292
    )
    
    
    19,260
    
    
    
    (6,310
    )
    
    
    (1,549
    )
    
    
    (891
    )Income tax benefit (provision)
    
    
    7,399
    
    
    
    (5,317
    )
    
    
    (586
    )
    
    
    220
    
    
    
    1,716Equity in income (loss) of affiliated
companies, net of tax
    
    
    3,341
    
    
    
    (11,670
    )
    
    
    
    
    
    
    8,329
    
    
    
    Net income (loss) from continuing
operations
    
    
    (1,552
    )
    
    
    2,273
    
    
    
    (6,896
    )
    
    
    7,000
    
    
    
    825Discontinued operations loss, net of tax
(Note 6)
    
    
    
    
    
    
    
    
    
    
    3,708
    
    
    
    
    
    
    
    3,708Net income (loss)
    
    
    (1,552
    )
    
    
    2,273
    
    
    
    (10,604
    )
    
    
    7,000
    
    
    
    (2,883
    )Other comprehensive income (loss)
    
    
    7
    
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    3Comprehensive income (loss)
    
    $
    (1,545
    )
    
    $
    2,273
    
    
    $
    (10,608
    )
    
    $
    7,000
    
    
    $
    (2,880
    )
 15




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##### Table of Contents



Condensed Consolidating Balance Sheet
As of December 31, 2003 Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Consolidating
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash
    
    $
    34,222
    
    
    $
    176
    
    
    $
    2,238
    
    
    $
    36,636
    
    
    $
    
    
    
    $
    36,636Accounts receivable, net
    
    
    10,487
    
    
    
    5,116
    
    
    
    6,424
    
    
    
    22,027
    
    
    
    
    
    
    
    22,027Inventories, net
    
    
    55,935
    
    
    
    13,174
    
    
    
    8,818
    
    
    
    77,927
    
    
    
    (4,792
    )
    
    
    73,135Other current assets
    
    
    5,844
    
    
    
    1,447
    
    
    
    713
    
    
    
    8,004
    
    
    
    1,446
    
    
    
    9,450Due from (due to) affiliated
companies
    
    
    508
    
    
    
    15,782
    
    
    
    (16,290
    )
    
    
    
    
    
    
    
    
    
    
    Total current assets
    
    
    106,996
    
    
    
    35,695
    
    
    
    1,903
    
    
    
    144,594
    
    
    
    (3,346
    )
    
    
    141,248Property, plant and equipment, net
    
    
    43,774
    
    
    
    19,791
    
    
    
    11,626
    
    
    
    75,191
    
    
    
    
    
    
    
    75,191Investment in subsidiaries
    
    
    66,128
    
    
    
    4,208
    
    
    
    
    
    
    
    70,336
    
    
    
    (70,336
    )
    
    
    Debt issuance costs and other
assets, net
    
    
    4,544
    
    
    
    13,475
    
    
    
    1,465
    
    
    
    19,484
    
    
    
    
    
    
    
    19,484Total assets
    
    $
    221,442
    
    
    $
    73,169
    
    
    $
    14,994
    
    
    $
    309,605
    
    
    $
    (73,682
    )
    
    $
    235,923LIABILITIES AND SHAREHOLDERS EQUITY
(DEFICIT)Current liabilities:Accounts payable
    
    $
    26,135
    
    
    $
    2,258
    
    
    $
    1,732
    
    
    $
    30,125
    
    
    $
    632
    
    
    $
    30,757Current maturity of related
party note payable
    
    
    675
    
    
    
    
    
    
    
    
    
    
    
    675
    
    
    
    
    
    
    
    675Current maturities of long-term
debt and capital lease
obligations
    
    
    10,096
    
    
    
    3
    
    
    
    
    
    
    
    10,099
    
    
    
    
    
    
    
    10,099Other current liabilities
    
    
    40,485
    
    
    
    6,826
    
    
    
    4,333
    
    
    
    51,644
    
    
    
    
    
    
    
    51,644Total current liabilities
    
    
    77,391
    
    
    
    9,087
    
    
    
    6,065
    
    
    
    92,543
    
    
    
    632
    
    
    
    93,175Long-term related party note
payable, net of current maturity
    
    
    687
    
    
    
    
    
    
    
    
    
    
    
    687
    
    
    
    
    
    
    
    687Long-term debt and capital lease
obligations, net of current
maturities
    
    
    311,777
    
    
    
    
    
    
    
    
    
    
    
    311,777
    
    
    
    
    
    
    
    311,777Other liabilities
    
    
    18,225
    
    
    
    2,549
    
    
    
    892
    
    
    
    21,666
    
    
    
    
    
    
    
    21,666Total liabilities
    
    
    408,080
    
    
    
    11,636
    
    
    
    6,957
    
    
    
    426,673
    
    
    
    632
    
    
    
    427,305Commitments
and contingencies
(Note 12)Shareholders equity (deficit):Preferred stock
    
    
    94,196
    
    
    
    
    
    
    
    
    
    
    
    94,196
    
    
    
    
    
    
    
    94,196Common stock
    
    
    1,524
    
    
    
    1,001
    
    
    
    29
    
    
    
    2,554
    
    
    
    (1,030
    )
    
    
    1,524Additional paid-in capital
    
    
    185,036
    
    
    
    3,031
    
    
    
    12,331
    
    
    
    200,398
    
    
    
    (15,362
    )
    
    
    185,036Retained earnings (accumulated
deficit)
    
    
    (467,391
    )
    
    
    57,501
    
    
    
    (3,558
    )
    
    
    (413,448
    )
    
    
    (57,922
    )
    
    
    (471,370
    )Accumulated comprehensive loss
    
    
    (3
    )
    
    
    
    
    
    
    (765
    )
    
    
    (768
    )
    
    
    
    
    
    
    (768
    )Total shareholders equity
(deficit)
    
    
    (186,638
    )
    
    
    61,533
    
    
    
    8,037
    
    
    
    (117,068
    )
    
    
    (74,314
    )
    
    
    (191,382
    )Total liabilities and
shareholders equity
(deficit)
    
    $
    221,442
    
    
    $
    73,169
    
    
    $
    14,994
    
    
    $
    309,605
    
    
    $
    (73,682
    )
    
    $
    235,923
 16




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##### Table of Contents



Condensed Consolidating Balance Sheet
As of June 30, 2004 Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Consolidating
    
    Eliminations
    
    ConsolidatedASSETSCurrent assets:Cash
    
    $
    17,800
    
    
    $
    287
    
    
    $
    2,332
    
    
    $
    20,419
    
    
    $
    
    
    
    $
    20,419Accounts receivable, net
    
    
    14,476
    
    
    
    4,533
    
    
    
    8,044
    
    
    
    27,053
    
    
    
    
    
    
    
    27,053Inventories, net
    
    
    59,197
    
    
    
    17,609
    
    
    
    12,716
    
    
    
    89,522
    
    
    
    (6,341
    )
    
    
    83,181Other current assets
    
    
    10,555
    
    
    
    2,305
    
    
    
    3,572
    
    
    
    16,432
    
    
    
    1,666
    
    
    
    18,098Due from (due to) affiliated
companies
    
    
    (881
    )
    
    
    29,347
    
    
    
    (28,466
    )
    
    
    
    
    
    
    
    
    
    
    Total current assets
    
    
    101,147
    
    
    
    54,081
    
    
    
    (1,802
    )
    
    
    153,426
    
    
    
    (4,675
    )
    
    
    148,751Property, plant and equipment, net
    
    
    40,418
    
    
    
    19,926
    
    
    
    8,625
    
    
    
    68,969
    
    
    
    
    
    
    
    68,969Investment in affiliates
    
    
    69,469
    
    
    
    (7,462
    )
    
    
    
    
    
    
    62,007
    
    
    
    (62,007
    )
    
    
    Debt issuance costs and other
assets, net
    
    
    11,534
    
    
    
    13,504
    
    
    
    871
    
    
    
    25,909
    
    
    
    
    
    
    
    25,909Total assets
    
    $
    222,568
    
    
    $
    80,049
    
    
    $
    7,694
    
    
    $
    310,311
    
    
    $
    (66,682
    )
    
    $
    243,629LIABILITIES AND SHAREHOLDERS EQUITY
(DEFICIT)Current liabilities:Accounts payable
    
    $
    19,447
    
    
    $
    2,177
    
    
    $
    1,786
    
    
    $
    23,410
    
    
    $
    632
    
    
    $
    24,042Current maturity of related
party note payable
    
    
    675
    
    
    
    
    
    
    
    
    
    
    
    675
    
    
    
    
    
    
    
    675Current maturities of long-term
debt and capital lease
obligations
    
    
    12,597
    
    
    
    224
    
    
    
    153
    
    
    
    12,974
    
    
    
    
    
    
    
    12,974Other current liabilities
    
    
    37,869
    
    
    
    10,753
    
    
    
    6,635
    
    
    
    55,257
    
    
    
    
    
    
    
    55,257Total current liabilities
    
    
    70,588
    
    
    
    13,154
    
    
    
    8,574
    
    
    
    92,316
    
    
    
    632
    
    
    
    92,948Long-term related party note
payable, net of current maturity
    
    
    687
    
    
    
    
    
    
    
    
    
    
    
    687
    
    
    
    
    
    
    
    687Long-term debt and capital lease
obligations, net of current
maturities
    
    
    457,979
    
    
    
    366
    
    
    
    391
    
    
    
    458,736
    
    
    
    
    
    
    
    458,736Other liabilities
    
    
    18,864
    
    
    
    2,723
    
    
    
    1,300
    
    
    
    22,887
    
    
    
    
    
    
    
    22,887Total liabilities
    
    
    548,118
    
    
    
    16,243
    
    
    
    10,265
    
    
    
    574,626
    
    
    
    632
    
    
    
    575,258Commitments
and contingencies
(Note 12)Shareholders equity (deficit)Common stock
    
    
    1,524
    
    
    
    1,001
    
    
    
    29
    
    
    
    2,554
    
    
    
    (1,030
    )
    
    
    1,524Additional paid-in capital
    
    
    141,865
    
    
    
    3,031
    
    
    
    12,331
    
    
    
    157,227
    
    
    
    (15,362
    )
    
    
    141,865Retained earnings (accumulated
deficit)
    
    
    (468,943
    )
    
    
    59,774
    
    
    
    (14,162
    )
    
    
    (423,331
    )
    
    
    (50,922
    )
    
    
    (474,253
    )Accumulated other comprehensive
income (loss)
    
    
    4
    
    
    
    
    
    
    
    (769
    )
    
    
    (765
    )
    
    
    
    
    
    
    (765
    )Total shareholders equity
(deficit)
    
    
    (325,550
    )
    
    
    63,806
    
    
    
    (2,571
    )
    
    
    (264,315
    )
    
    
    (67,314
    )
    
    
    (331,629
    )Total liabilities and
shareholders equity
(deficit)
    
    $
    222,568
    
    
    $
    80,049
    
    
    $
    7,694
    
    
    $
    310,311
    
    
    $
    (66,682
    )
    
    $
    243,629
 17




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##### Table of Contents



Condensed Consolidating Cash Flow Statement
For the Six Months Ended June 30, 2003 Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Eliminations
    
    ConsolidatedNet cash provided by (used in) operating
activities
    
    $
    (27,284
    )
    
    $
    12,234
    
    
    $
    3,345
    
    
    $
    
    
    
    $
    (11,705
    )Cash flows from investing activities:Purchases of property, plant and equipment
    
    
    (4,610
    )
    
    
    (1,506
    )
    
    
    (2,430
    )
    
    
    
    
    
    
    (8,546
    )Payment for acquisition, net of cash acquired
    
    
    (1,799
    )
    
    
    (10,631
    )
    
    
    
    
    
    
    
    
    
    
    (12,430
    )Proceeds from the sale of property, plant
and equipment
    
    
    23
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23Net cash used in investing activities
    
    
    (6,386
    )
    
    
    (12,137
    )
    
    
    (2,430
    )
    
    
    
    
    
    
    (20,953
    )Cash flows from financing activities:Payments under Senior Credit
Facility
    
    
    (14,187
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (14,187
    )Book overdraft
    
    
    (1,318
    )
    
    
    514
    
    
    
    
    
    
    
    
    
    
    
    (804
    )Payments of principal under capital lease
obligations
    
    
    (611
    )
    
    
    
    
    
    
    (554
    )
    
    
    
    
    
    
    (1,165
    )Payment of principal of other bank debt
    
    
    
    
    
    
    (750
    )
    
    
    
    
    
    
    
    
    
    
    (750
    )Net cash used in financing activities
    
    
    (16,116
    )
    
    
    (236
    )
    
    
    (554
    )
    
    
    
    
    
    
    (16,906
    )Effect of cumulative translation adjustment
    
    
    (10
    )
    
    
    
    
    
    
    353
    
    
    
    
    
    
    
    343Net increase (decrease) in cash
    
    
    (49,796
    )
    
    
    (139
    )
    
    
    714
    
    
    
    
    
    
    
    (49,221
    )Cash at beginning of year
    
    
    66,775
    
    
    
    317
    
    
    
    1,019
    
    
    
    
    
    
    
    68,111Cash at end of period
    
    $
    16,979
    
    
    $
    178
    
    
    $
    1,733
    
    
    $
    
    
    
    $
    18,890
 Condensed Consolidating Cash Flow Statement
For the Six Months Ended June 30, 2004 Non-Borrower
    
    Guarantors
    
    Guarantors
    
    Eliminations
    
    ConsolidatedNet cash provided by (used in) operating
activities
    
    $
    (15,789
    )
    
    $
    2,088
    
    
    $
    878
    
    
    $
    
    
    
    $
    (12,823
    )Cash flows from investing activities:Purchases of property, plant and equipment
    
    
    (1,343
    )
    
    
    (940
    )
    
    
    (753
    )
    
    
    
    
    
    
    (3,036
    )Proceeds from the sale of property, plant
and equipment
    
    
    
    
    
    
    4
    
    
    
    
    

    
    
    
    
    
    
    4Net cash used in investing activities
    
    
    (1,343
    )
    
    
    (936
    )
    
    
    (753
    )
    
    
    
    
    
    
    (3,032
    )Cash flows from financing activities:Book overdraft
    
    
    966
    
    
    
    (926
    )
    
    
    
    
    
    
    
    
    
    
    40Payments of principal under capital lease
obligations
    
    
    (657
    )
    
    
    (115
    )
    
    
    (27
    )
    
    
    
    
    
    
    (799
    )Payments of principal under Senior Credit
Facility
    
    
    (168,682
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (168,682
    )Payments of principal under New Senior
Credit Facility
    
    
    (2,500
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,500
    )Proceeds from borrowings under New Senior
Credit Facility
    
    
    320,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    320,000Debt issuance costs
    
    
    (9,125
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,125
    )Payment of preferred stock repurchase
    
    
    (109,459
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (109,459
    )Payments of preferred stock dividends
    
    
    (29,541
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (29,541
    )Preferred stock repurchase costs
    
    
    (299
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (299
    )Net cash provided by (used in)
financing activities
    
    
    703
    
    
    
    (1,041
    )
    
    
    (27
    )
    
    
    
    
    
    
    (365
    )Effect of cumulative translation adjustment
    
    
    7
    
    
    
    
    
    
    
    (4
    )
    
    
    
    
    
    
    3Net increase (decrease) in cash
    
    
    (16,422
    )
    
    
    111
    
    
    
    94
    
    
    
    
    
    
    
    (16,217
    )Cash at beginning of year
    
    
    34,222
    
    
    
    176
    
    
    
    2,238
    
    
    
    
    
    
    
    36,636Cash at end of period
    
    $
    17,800
    
    
    $
    287
    
    
    $
    2,332
    
    
    $
    
    
    
    $
    20,419
 18




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##### Table of Contents



12. Commitments and Contingencies The Company is engaged in various legal proceedings incidental to its
normal business activities. Management believes that the amounts, if any, which
ultimately may be due in connection with such lawsuits and claims would not
have a material effect upon the Company, because most of the claims are covered
by insurance. The Company is also engaged in product recall campaigns related to its
normal business activities. Management believes that the costs, if any,
associated with the product recalls would not have a material effect upon the
Company. 19




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##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS. The following discussion and analysis should be read in conjunction with
the Companys unaudited consolidated financial statements and accompanying
notes thereto, which are included elsewhere herein. Unless otherwise mentioned,
all references to the number of Decorating Consultants, number of orders
shipped, average order size, and fulfillment rate relate to domestic direct
sales activity only. Special Note Regarding Forward-Looking Statements Some of the statements under Managements Discussion and Analysis of
Financial Condition and Results of Operations and elsewhere in this report
constitute forward-looking statements. These statements involve known and
unknown risks, uncertainties and other factors that may cause the Companys
actual results to be materially different from any future results expressed or
implied by such forward-looking statements. In some cases, forward-looking statements are identified by terminology
such as may, will, should, expects, plans, anticipates, believes,
estimates, predicts, potential or continue or the negative of such
terms or other comparable terminology. All of these forward-looking statements are based on estimates and
assumptions made by management of the Company, which, although believed to be
reasonable, are inherently uncertain. Therefore, undue reliance should not be
placed upon such statements. No assurance can be given that any of such
estimates or statements will be realized and actual results may differ
materially from those contemplated by such forward-looking statements. Factors
that may cause such differences include: (i) Decorating Consultant recruiting
and activity levels; (ii) loss or retirement of key members of management;
(iii) imposition of foreign, federal or state taxes; (iv) change in status of
independent contractors; (v) increased competition; (vi) the success of new
products and promotion programs; (vii) general economic conditions and (viii)
the success of integrating acquired businesses. Many of these factors will be
beyond the control of the Company. Moreover, neither the Company nor any other person assumes responsibility
for the accuracy and completeness of such statements. The Company is under no
duty to update any of the forward-looking statements after the date of this
Form 10-Q to conform such statements to actual results. Company Background The Company believes it is the largest direct seller of home decorative
accessories in the United States, as measured by sales. As of June 30, 2004,
the Company has approximately 95,600 active Decorating Consultants located in
the United States, Mexico, Canada and Puerto Rico. The Companys direct sales
are dependent upon the number of Decorating Consultants selling the Companys
products and their resulting productivity. Decorating Consultant productivity
fluctuates from time to time based on seasonality and special marketing
programs, which offer Decorating Consultants new incentives and discounts timed
to generate additional sales. The Company also sells products to customers
outside of its direct selling channel. To stimulate sales within the direct selling channel, the Company offers a
variety of discounts and incentives to Decorating Consultants. The amount and
timing of discounts and incentives vary from year to year. The cost of
discounts is reflected in the Companys net sales while the cost of incentives
is reflected in selling expense. Company Direct Selling Strategy The Company has evolved its strategy to put greater focus on what
management believes to be the key drivers of the direct selling business -
recruiting, retention and productivity of the Decorating Consultant base. The Company recognizes the need to continue to attract and retain new
Decorating Consultants. As of June 30, 2004, the Companys active Decorating
Consultant base in the United States increased 4.6% to approximately 71,200
active Decorating Consultants from approximately 68,100 as of June 30, 2003.
This increase was a result of the Companys continued focus on key areas such
as Decorating Consultant understanding and awareness of the 20




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Hostess program, improved training and business guides, and a more clearly
defined and communicated career path as reflected in the new recruit program. The retention of experienced Decorating Consultants requires operational
focus on several areas: product distribution fulfillment rates, product
selection and sales training and motivation. Fulfillment rates for product
distribution remained strong at approximately 99% as of June 30, 2004. The
Company is continuing to introduce new products during 2004, which complement
the current line of products, in an attempt to give the product line a fresh
and more innovative look. The Companys Recertification program educates
Decorating Consultants on how to become more effective directors and trainers
by helping them develop and enhance their leadership skills. Decorating
Consultant training and motivation requires the introduction of sales promotion
and development activities directed at helping Decorating Consultants increase
their productivity. Sales tools such as Power Paks and the Companys HIG
Creative Concepts DVD/video series have helped the field leadership plan and
present more effective sales meetings and training sessions for the Decorating
Consultants. Company Manufacturing and Wholesale Strategy The Company refers to its manufacturing or wholesale supply operations as
Domistyle, a uniquely positioned home décor manufacturing and design
operation that not only sells to the Companys core direct selling business,
but also sells to non-affiliated retailers. The Company continues to emphasize products from its wholesale supply
operation in the direct selling channel, which the Company believes provides
opportunities for gross margin improvements and leverages the fixed expense
component of its cost structure. During the six months ended June 30, 2004,
approximately 53% of the dollar volume of products purchased for the direct
selling channel of the Company was purchased from, and manufactured by, the
Companys subsidiaries. The Company believes that this increased focus of the
Companys manufacturing strategy has supported Decorating Consultant
productivity and retention through increased fulfillment rates and increased
flexibility related to promotion strategies. The Companys Domistyle operation increased net sales to non-affiliated
retailers by $3.2 million or 29.8% for the six months ended June 30, 2004.
Wholesale supply net sales by the Company were $14.1 million for the six months
ended June 30, 2004, as compared to $10.9 million for the six months ended June
30, 2003. Recent Developments Three Month Period
Ended June 30, 2004  Discontinued Operations In April 2004, the Company made the decision to discontinue the
manufacture and distribution of ceramics products due to the loss of a major
retail customer to an overseas manufacturer. On April 28, 2004, ceramics
manufacturing was shut down. The Company has incurred approximately $0.6
million in severance costs, $0.1 million in contract termination costs, $1.3
million in impairment of property, plant and equipment, and $1.1 million in
impairment of goodwill related to the shut down and disposal activity. The
remaining assets related to the manufacture of ceramic products have been
classified as assets held for sale in the consolidated statement of financial
position, and the Company anticipates disposing of all assets within one year. The Company has accounted for the shutdown of the manufacturing efforts of
ceramic products as discontinued operations in the consolidated statements of
operations and comprehensive income as of June 30, 2004. The operations and
cash flows of the ceramics manufacturing operation have been eliminated from
the Companys ongoing operations and information presented for all periods
reflects the new classification. The operations of the ceramics manufacturing
were previously reported in the Companys Domistyle operating segment. The
loss on discontinued operations of ceramics manufacturing was $3.7 million for
the six months ended June 30, 2004 and $0.9 million for the six months ended
June 30, 2003. In May, 2004 the Company made the decision to discontinue the manufacture
of glass products due to issues with the quality and color of the glass
products produced and ongoing operating losses. On June 28, 2004 the glass
manufacturing plant was shut down. The Company has incurred approximately $0.8
million in severance costs, $0.1 million in contract termination costs, and
$0.9 million in impairment of property, plant and equipment related to the 21




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glass plant closure. The remaining assets of the glass manufacturing
plant have been classified as assets held for sale in the consolidated
statement of financial position, and the Company anticipates disposing of all
assets within one year. Total costs incurred related to this shutdown are
reflected in continuing operations in the consolidated statement of operations
and comprehensive income for the period ended June 30, 2004, since the Company
will continue to source glass products from non-affiliated vendors and
distribute glass products to non-affiliated retailers. Results of Operations The three months ended June 30, 2004 compared to the three months ended June
30, 2003 Amount
    
    Percentage2003
    
    2004
    
    Variance
    
    VarianceNet SalesDomestic direct net sales to non-affiliates
    
    $
    131,535
    
    
    $
    110,751
    
    
    $
    (20,784
    )
    
    
    (15.8
    )%International direct net sales to non-affiliates
    
    
    14,351
    
    
    
    16,122
    
    
    
    1,771
    
    
    
    12.3
    %Domistyle net sales to non-affiliates
    
    
    4,932
    
    
    
    6,002
    
    
    
    1,070
    
    
    
    21.7
    %Net sales
    
    $
    150,818
    
    
    $
    132,875
    
    
    $
    (17,943
    )
    
    
    (11.9
    )%Other Key Domestic DataNumber of average active Decorating Consultants
    
    
    65,800
    
    
    
    71,700
    
    
    
    5,900
    
    
    
    9.0
    %Number of average active international
Decorating Consultants
    
    
    17,600
    
    
    
    23,200
    
    
    
    5,600
    
    
    
    31.8
    %Number of orders shipped
    
    
    248,477
    
    
    
    222,742
    
    
    
    (25,735
    )
    
    
    (10.4
    )%Number of orders per Decorating Consultant
    
    
    3.8
    
    
    
    3.1
    
    
    
    (0.7
    )
    
    
    (18.4
    )%Average order size (actual dollars)
    
    $
    529
    
    
    $
    497
    
    
    $
    (32
    )
    
    
    (6.0
    )%
 Net sales decreased $17.9 million, or 11.9%, to $132.9 million in the
three months ended June 30, 2004 from $150.8 million in the comparable period
in 2003. Domestic direct net sales to non-affiliates decreased $20.8 million,
or 15.8%, in the three months ended June 30, 2004 as compared to the three
months ended June 30, 2003. The Company believes that several
contributing factors impacted the results of the domestic direct net
sales in the first half of 2004 including the management transition
from a family member CEO to an independent CEO, effective January
2004, the number of Decorating Consultants, the number of orders
shipped, the number of orders per Decorating Consultant and average
order size. The average order size decreased 6.0% to $497 in the three months ended June
30, 2004 as compared to $529 for the comparable period in 2003. The Company
believes the decrease in average order size is due to the increase of new
Decorating Consultants, who are historically less productive, an increase in
individual customer brochure product sales, the timing of incentive promotions,
and cautious consumer spending resulting from economic concerns. International
direct net sales to non-affiliates increased $1.8 million, or 12.3%, in the
three months ended June 30, 2004 as compared to the three months ended June 30,
2003. This increase in net sales was primarily related to the increase in the
number of Decorating Consultants in Mexico, Canada and Puerto Rico. The average
number of international active Decorating Consultants increased 31.8% to 23,200
for the three-month period ending June 30, 2004 from 17,600 in the comparable
period in 2003. Domistyle net sales to non-affiliates increased 21.7%, or $1.1
million, over the comparable periods as the Company continues to expand the
wholesale supply channel. Gross profit decreased $13.3 million, or 15.7%, to $71.6 million in the
three months ended June 30, 2004 from $84.9 million in the three months ended
June 30, 2003. As a percentage of net sales, gross profit decreased to 53.9% in
2004 from 56.3% in 2003. As the international direct net sales and Domistyle
net sales increased, gross profit as a percentage of total net sales declined
slightly, since the international direct net sales and Domistyle net sales
generally have a lower margin than domestic direct net sales. In addition,
metal and glass product manufacturing was operating at negative gross margins
due to operating inefficiencies, inventory write offs, and redundant
facilities. The impact to gross profit was a $2.2 million decrease for the
three months ended June 30, 2004, compared to a $1.0 million decrease for the
same period in 2003. In June 2004 glass product manufacturing operations were
shut down, and metal product manufacturing operations were consolidated into
one Company owned facility. Selling expense increased $0.7 million, or 2.9%, to $27.0 million in the
three months ended June 30, 2004 from $26.3 million in the comparable period of
2003. As a percentage of net sales, selling expense increased to 20.3% for the
three-month period ended June 30, 2004 from 17.4% in the comparable period of
2003. The increase as a percentage of net sales is primarily due to new royalty
agreements on net product sales in 2004, and the cost and 22




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timing of accruals for sales events and incentive trips. Royalty expense
on product net sales related to the new royalty agreements was $0.9 million in
the three-month period ended June 30, 2004. Freight, warehouse and distribution expense decreased $0.9 million, or
4.8%, to $17.4 million in the three months ended June 30, 2004 from $18.3
million in the three months ended June 30, 2003. These costs were 13.1% of net
sales in the 2004 period, as compared to 12.1% in the comparable 2003 period. General and administrative expense increased $1.2 million, or 7.8%, to
$17.3 million in the three months ended June 30, 2004, from $16.1 million in
the three months ended June 30, 2003. The increase was related to fees incurred
for strategic consulting services provided to the Company. Stock option expense related to the options issued under the 1998 and 2002
Key Employee Stock Option Plans and the 1998 Independent Contractor Stock
Option Plan of approximately $0.9 million was recorded in the three months
ended June 30, 2004, as compared to $1.3 million in the comparable 2003 period. The six months ended June 30, 2004 compared to the six months ended June 30,
2003 Amount
    
    Percentage2003
    
    2004
    
    Variance
    
    VarianceNet SalesDomestic direct net sales to non-affiliates
    
    $
    241,453
    
    
    $
    219,280
    
    
    $
    (22,173
    )
    
    
    (9.2
    )%International direct net sales to non-affiliates
    
    
    24,444
    
    
    
    30,382
    
    
    
    5,938
    
    
    
    24.3
    %Domistyle net sales to non-affiliates
    
    
    10,887
    
    
    
    14,129
    
    
    
    3,242
    
    
    
    29.8
    %Net sales
    
    $
    276,784
    
    
    $
    263,791
    
    
    $
    (12,993
    )
    
    
    (4.7
    )%Other Key Domestic DataNumber of average active Decorating Consultants
    
    
    65,200
    
    
    
    71,400
    
    
    
    6,200
    
    
    
    9.5
    %Number of average active international
Decorating Consultants
    
    
    17,800
    
    
    
    24,600
    
    
    
    6,800
    
    
    
    38.2
    %Number of orders shipped
    
    
    462,743
    
    
    
    466,474
    
    
    
    3,731
    
    
    
    0.8
    %Number of orders per Decorating Consultant
    
    
    7.1
    
    
    
    6.5
    
    
    
    (0.6
    )
    
    
    (8.5
    )%Average order size (actual dollars)
    
    $
    522
    
    
    $
    470
    
    
    $
    (52
    )
    
    
    (10.0
    )%
 Net sales decreased $13.0 million, or 4.7%, to $263.8 million in the six
months ended June 30, 2004 from $276.8 million in the comparable period in
2003. Domestic direct net sales to non-affiliates decreased $22.2 million, or
9.2%, in the six months ended June 30, 2004 as compared to the six months ended
June 30, 2003. The Company believes that several contributing
factors impacted the results of the domestic direct net sales in the
first half of 2004 including the management transition from a family
member CEO to an independent CEO, effective January 2004, the
number of Decorating Consultants, the number of orders shipped, the
number of orders per Decorating Consultant and average order size. The average
order size decreased 10.0% to $470 in the six months ended June 30, 2004 as
compared to $522 for the comparable period in 2003. The Company believes the
decrease in average order size is due to the increase of new Decorating
Consultants, who are historically less productive, an increase in individual
customer brochure product sales, the timing of incentive promotions, and
cautious consumer spending resulting from economic concerns. International
direct net sales to non-affiliates increased $5.9 million, or 24.3%, in the
comparable six-month periods primarily related to the increase in the number of
Decorating Consultants in Mexico, Canada and Puerto Rico. The average number of
international active Decorating Consultants increased 38.2% to 24,600 for the
six-month period ending June 30, 2004 from 17,800 in the comparable period in
2003. Domistyle net sales to non-affiliates increased 29.8% or $3.2 million
over the comparable periods as the Company continues to expand the wholesale
supply channel. Gross profit decreased $12.5 million, or 8.0%, to $144.0 million in the
six months ended June 30, 2004 from $156.5 million in the six months ended June
30, 2003. As a percentage of net sales, gross profit decreased to 54.6% in 2004
from 56.5% in 2003. As the international direct net sales and Domistyle net
sales increased, gross profit as a percentage of total net sales declined
slightly, since the international direct net sales and Domistyle net sales
generally have a lower margin than domestic Decorating Consultant net sales.
In addition, metals and glass manufacturing was operating at negative gross
margins due to operating inefficiencies, inventory write offs, and redundant
facilities. The impact to gross profit was a $2.2 million decrease for the
three months ended June 30, 2004 compared to a $1.0 million decrease for the
same period in 2003. In June 2004 glass manufacturing operations were shut
down, and metals manufacturing operations were consolidated in one Company
owned facility. 23




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Selling expense increased $7.1 million, or 15.2%, to $53.9 million in the
six months ended June 30, 2004 from $46.8 million in the comparable period of
2003. As a percentage of net sales, selling expense increased to 20.4% for the
six-month period ended June 30, 2004 from 16.9% in the comparable period of
2003. The increase as a percentage of net sales is primarily due to new royalty
agreements on product sales in 2004, and the cost and timing of accruals for
sales events and incentive trips. Royalty expense on product net sales
related to the new royalty agreements was $1.7 million in 2004. The cost and
timing of accruals for sales events and incentive trips was $4.6 million during
the six months ended June 30, 2004, as compared to $1.5 million for the
comparable period in 2004. In addition, in 2003 there was a one-time benefit
related to expired sales incentive certificates of $1.6 million. Freight, warehouse and distribution expense increased $0.5 million, or
1.5%, to $34.4 million in the six months ended June 30, 2004 from $33.9 million
in the six months ended June 30, 2003. These costs were 13.0% of net sales in
the 2004 period, as compared to 12.2% in the comparable 2003 period. This
increase in freight, warehouse and distribution expense as a percentage of
sales was primarily due to the increase in freight, labor and packaging
supplies costs as a result of the 0.8% increase in the number of domestic
orders shipped in 2004 over the comparable period of 2003 and the 10.0%
decrease in the average order size. General and administrative expense increased $3.4 million, or 10.8%, to
$35.0 million in the six months ended June 30, 2004, from $31.6 million in the
six months ended June 30, 2003. The increase consists primarily of $2.1 million
in fees incurred for strategic consulting services provided to the Company
during 2004. Included in general and administrative expense are certain
additional non-recurring costs related to excess facilities, corporate
organizational realignment expenses, and strategic planning consulting
expenses. These costs were approximately $3.8 million and $0.5 million for the
six months ended June 30, 2004 and 2003, respectively. Loss on debt refinancing of $1.1 million in 2004 was a result of the
write-off of $0.4 million of unamortized debt issuance costs and $0.7 million
of legal and advisory fees related to the debt restructure in March, 2004. Stock option expense related to the options issued under the 1998 and 2002
Key Employee Stock Option Plans and the 1998 Independent Contractor Stock
Option Plan of approximately $1.9 million was recorded in the six months ended
June 30, 2004, as compared to $2.2 million in the comparable 2003 period. Segment Analysis The Companys reportable segments include its domestic and international
direct sales operations and Domistyle. The Companys manufacturing operations
are part of the Domistyle segment, which sells the majority of its products to
the Company. As a result, Domistyle sales generally follow the Companys
domestic sales trend. International operations include direct sales by
Decorating Consultants in Mexico, Canada and Puerto Rico. International direct
sales are directly attributable to the number of international Decorating
Consultants the Company has selling its products. The three months ended June 30, 2004 compared to the three months ended June
30, 2003 Consolidated net sales decreased $17.9 million, or 11.9%, to $132.9
million in the three months ended June 30, 2004, from $150.8 million in the
comparable 2003 period. See discussion in Results of Operations. Direct Selling Domestic Domestic net sales to non-affiliates and affiliates decreased $25.8
million, or 17.8% to $119.3 million in the three months ended June 30, 2004
from $145.1 million in the same period of 2003. Domestic net sales to
non-affiliates decreased $20.8 million, or 15.8%, to $110.7 million for the
second quarter 2004 from $131.5 million for the second quarter 2003. The
primary sales drivers for non-affiliate sales are average order size,
Decorating Consultant productivity, and number of active Decorating
Consultants. Average order size decreased 6.0% to $497 in the second quarter of
2004 from $529 in the first quarter of 2003. Number of orders shipped
decreased 10.4% to approximately 223,000 in the three months ended June 30,
2004 compared to approximately 248,000 in the same 24




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period in 2003. Net sales to affiliates decreased $5.1 million, or 37.5%,
to $8.5 million in the three months ended June 30, 2004 from $13.6 million in
the three months ended June 30, 2003. International International direct sales include sales in Mexico, Canada and Puerto
Rico. These sales increased $1.8 million, or 12.3%, to $16.1 million in the
three months ended June 30, 2004 from $14.3 million in the three months ended
June 30, 2003. This increase is primarily due to the increase in the Decorating
Consultant base in Mexico, Canada, and Puerto Rico. As of June 30, 2004, the
Decorating Consultant base was approximately 22,100, 1,300 and 1,000 in Mexico,
Canada and Puerto Rico, respectively, as compared to 17,700, 1,000 and 600 in
the comparable period of 2003. Domistyle The Company is in the process of expanding its wholesale supply sales to
non-affiliate resellers through its Domistyle segment. Net sales to
non-affiliate resellers for the three-month period increased $1.1 million, or
21.7%, to $6.0 million in 2004 as compared to $4.9 million in the comparable
period of 2003. The increased net sales to non-affiliate resellers accounted
for 15.3% of Domistyle net sales in the three months ended June 30, 2004 as
compared to 11.7% in the three months ended June 30, 2003. Net sales to
affiliates decreased $3.6 million, or 9.8%, to $33.3 million in the three-month
period ended June 30, 2004 from $36.9 million in the same period of 2003. The
decrease was a result of the decline in product demand from the Companys
non-affiliated direct selling domestic segment. The six months ended June 30, 2004 compared to the six months ended June 30,
2003 Consolidated net sales decreased $13.0 million, or 4.7%, to $263.8 million
in the six months ended June 30, 2004, from $276.8 million in the six months
ended June 30, 2003. See discussion in Results of Operations. Direct Selling Domestic Domestic net sales to non-affiliates and affiliates decreased $25.2
million, or 9.7%, to $234.5 million in the six months ended June 30, 2004 from
$259.7 million in the same period of 2003. Domestic net sales to non-affiliates
decreased $22.2 million, or 9.2%, to $219.3 million in 2004 from $241.5 million
in 2003. The primary sales drivers for non-affiliate sales are average order
size, Decorating Consultant productivity, and number of active Decorating
Consultants. Average order size decreased 10.0% to $470 in the six months ended
June 30, 2004 from $522 in the same period of 2003. Number of orders shipped
increased 0.8% to 466,474 in 2004 compared to 462,743 in 2003. The average
number of active Decorating Consultants increased to 71,400 in 2004 from 65,200
in 2003. Net sales to affiliates decreased $3.0 million, or 16.5% to $15.2
million in the six months ended June 30, 2004 from $18.2 million in the six
months ended June 30, 2003. International International direct net sales include sales in Mexico, Canada and Puerto
Rico. Net sales increased $5.9 million, or 24.3%, to $30.3 million in the six
months ended June 30, 2004 from $24.4 million in the six months ended June 30,
2003. This increase was primarily due to the increase in the Decorating
Consultant base in Mexico, Canada, and Puerto Rico. As of June 30, 2004, the
Decorating Consultant base was approximately 22,100, 1,300 and 1,000 in Mexico,
Canada and Puerto Rico, respectively, as compared to 17,700, 1,000 and 600 in
the comparable period of 2003. Domistyle The Company is in the process of expanding its wholesale supply sales to
non-affiliate resellers through its Domistyle segment. Net sales to
non-affiliate resellers for the six-month period increased $3.2 million, or
29.8%, to $14.1 million in 2004 as compared to $10.9 million in the comparable
period of 2003. The increase in net sales to 25




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non-affiliate resellers accounted for 17.1% of Domistyle net sales in the
six months ended June 30, 2004 as compared to 13.4% in the six months ended
June 30, 2003. Net sales to affiliates decreased $1.7 million, or 2.4%, to
$68.5 million in the six months ended June 30, 2004 from $70.2 million in the
same period of 2003. The decrease is a result of the decline in product demand
from the Companys non-affiliated direct selling domestic segment. Seasonality The Companys business is influenced by the Christmas holiday season and
by promotional events. Historically, a higher portion of the Companys net
sales and net income have been realized during the fourth quarter. Net sales
have generally been slightly lower during the first quarter as compared to the
second and third quarters, and net income has generally been the lowest during
the third quarter. Working capital requirements also fluctuate during the
year. Working capital requirements are at the highest levels during the third
and fourth quarters as the Company increases inventory for the peak season. In
addition to the Companys peak season fluctuations, quarterly results of
operations may fluctuate depending on the timing of, and amount of sales from,
discounts, incentive promotions and/or the introduction of new products. As a
result, the Companys business activities and results of operations in any
quarter are not necessarily indicative of any future trends in the Companys
business. Liquidity and Capital Resources At
June 30, 2004, The Company had $20.4 million in cash and $45.8
million, net of outstanding letters of credit, available under the
$50.0 million Revolving Loans. The
Company believes that cash on hand, net cash flow from operations,
and borrowings under the Revolving Loans will be sufficient to fund
its cash requirements through the twelve months ended June 30,
2005. Cash requirements will consist primarily of payments of
principal and interest on outstanding indebtedness, working capital
requirements, and capital expenditures. The Companys future
operating performance and ability to service or refinance its current
indebtedness will be subject to future economic conditions and to
financial, business and other factors, many of which are beyond the
Companys control. The Companys cash decreased $16.2 million from $36.6 million as of
December 30, 2003, to $20.4 million at June 30, 2004. The decrease resulted
primarily from $12.8 million, $3.0 million, and $0.4 million of net cash used
by operating, investing, and financing activities, respectively. Net cash of $12.8 million used by operating activities consisted primarily
of $14.4 million provided by net income, as adjusted for non-cash items, and
$27.2 million used by working capital. Working capital usage consisted
primarily of a $11.1 million increase in inventory balances, a $6.7 million
increase in accounts receivable, a $3.8 million increase in prepaid expenses, a
$2.8 million increase in the deferred income tax benefit, a $2.9 million
decrease in income tax payable and a decrease of $6.6 in accounts payable,
which was offset by a $6.0 million increase in deferred revenue. Net cash of $3.0 million used in investing activities was a result of
approximately $3.0 million of cash used for the purchase of property, plant,
and equipment. Net cash of $0.4 million used in financing activities was primarily a
result of the Companys refinancing of its existing credit facility plus a $2.5
million new senior credit facility principal payment made as of June 30, 2004. Refinancing of Senior Credit Facility On March 31, 2004, the Company entered into a senior credit facility, New
Senior Credit Facility, with Bear Stearns Corporate Lending Inc., as
syndication agent, JPMorgan Chase Bank, as administrative agent, and the
several lenders from time to time parties thereto, pursuant to which the
Company, among other things, refinanced loans outstanding under the Companys
existing credit facility. The New Senior Credit Facility provides a seven-year
term loan facility of up to $320.0 million, Term Loans, and a $50.0 million
five-year revolving credit facility, Revolving Loans. 26




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On March 31, 2004, $320.0 million in proceeds received from the Term Loans
were used to complete the following transactions:  
    
    For an aggregate purchase price of $139.0 million, the Company
repurchased all of the Companys outstanding shares of its 12.5%
Senior Convertible Preferred Stock, pursuant to a Stock Purchase
Agreement, dated March 31, 2004, among the Company and certain
affiliates of the Companys controlling stockholders the Preferred
Stock Repurchase.
    
    $169.1 million of the proceeds were used to pay off the existing
credit facility which included an outstanding debt balance, related
partial year interest, commitment fees, and outstanding letter of
credit fees.
    
    $9.4 million of the proceeds were used to pay legal and advisory
fees associated with the Preferred Stock Repurchase and to pay off of
the existing credit facility, and New Senior Credit Facility debt
issuance costs. There were no amounts drawn under the Revolving Loans and the remaining
Term Loans proceeds of approximately $2.5 million were used for general working
capital purposes. Borrowings under the New Senior Credit Facility require quarterly
principal and interest payments. The term loan facility matures on March 31,
2011 and the revolving loan facility matures on March 31, 2009 provided that in
the event that the senior subordinated notes (Notes) are not refinanced in
whole on or prior to December 1, 2007 through the issuance of refinancing
securities with a maturity no less than six months after March 31, 2011,
incremental term loans, or an initial public offering then all Term Loans
outstanding will be due and payable and the revolving credit facility will
terminate on that date. Accordingly, the Company is amortizing its debt
issuance costs over the period from March 31, 2004 through December 1, 2007.
The Company may, at its option, prepay the Term Loans and Revolving Loans
without premium or penalty provided that in certain circumstances prepayment of
the Term Loans on or prior to the first anniversary of the closing date of the
New Senior Credit Facility must be accompanied by a 1% prepayment premium.
Additionally, the Company may reduce or eliminate its revolving loan commitment
prior to maturity. The New Senior Credit Facility is guaranteed
unconditionally on a senior basis by the Companys wholly owned domestic
subsidiaries and is collateralized by a lien on substantially all assets of the
Company and its wholly owned domestic subsidiaries. There are no material
restrictions on the Companys ability to obtain funds from its wholly owned
subsidiaries by dividend or otherwise. The Term Loans under the New Senior Credit Facility bear interest, at the
Companys election, at either LIBOR plus an applicable margin or the Alternate
Base Rate plus an applicable margin. The Alternate Base Rate is the higher of
the prime rate of JPMorgan Chase Bank, the Base CD rate in effect plus 1%, or
the federal funds effective rate plus 0.5%. For the Revolving Loans the
applicable LIBOR margin and Alternate Base Rate margin are subject to
adjustments, upwards or downwards after December 31, 2004, based upon the
leverage ratio as defined by the New Senior Credit Agreement. The interest
rates on all borrowings outstanding under the New Senior Credit Facility were
based on LIBOR as of June 30, 2004. As of June 30, 2004, term borrowings
outstanding totaled $317.5 million. The weighted-average interest rate on the
Term Loan borrowings outstanding at June 30, 2004 was 5.41%. The Revolving Loans are subject to a commitment fee based on the undrawn
portion of the Revolving Loans. The commitment fee is eligible for certain
performance pricing step-downs and was 0.5% per annum as of June 30, 2004.
Outstanding letters of credit totaled $4.2 million as of June 30, 2004. Payments on the Notes and the New Senior Credit Facility represent
significant cash requirements for the Company. Interest payments on the Notes
commenced in December 1998 and continue semi-annually until the Notes mature in
2008. The Company has the option to redeem the Notes in whole or in part at any
time. The Term Loans under the New Senior Credit Facility require quarterly
interest and principal payments. In addition, the New Senior Credit Facility
includes a $50.0 million five-year revolving credit facility, which matures on
March 31, 2009. As of June 30, 2004, there were no outstanding Revolving Loans. 27




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##### Table of Contents



During the six months ended June 30, 2004, the Company paid a total of
$14.6 million in debt service, consisting of principal payments under the New
Senior Credit Facility of $2.5 million, interest and commitment fees under the
New Senior Credit Facility of approximately $4.6 million, and interest on the
Notes of approximately $7.5 million. The terms of the Notes and New Senior Credit Facility include significant
operating and financial restrictions, such as limits on the Companys ability
to incur indebtedness, create liens, sell assets, engage in mergers,
acquisitions or consolidations, make investments and pay dividends. In
addition, under the New Senior Credit Facility, the Company is required to
comply with specified financial ratios and tests, an interest coverage ratio,
maximum leverage ratio, and maximum capital expenditures as defined per the New
Senior Credit Facility agreement. As of June 30, 2004, the Company was in compliance with all covenants and
other requirements set forth in the credit agreement under the New Credit
Facility and indenture with respect to the Notes. Further, the Company does not
have any rating downgrade triggers that would accelerate maturity dates of its
debt. Contractual Obligations The following table summarizes the Companys contractual obligations at
June 30, 2004 and the effects such obligations are expected to have on its
liquidity and cash flow in future periods (in thousands). Payments Due by PeriodLess than
    
    1 - 3
    
    4 - 5
    
    After 5TOTAL
    
    1 Year
    
    Years
    
    Years
    
    YearsLong-term debt
    
    $
    466,600
    
    
    $
    11,250
    
    
    $
    455,350
    
    
    $
    
    
    
    $
    Capital lease obligations
    
    
    5,110
    
    
    
    1,745
    
    
    
    3,365
    
    
    
    
    
    
    
    Related-party note payable
    
    
    1,362
    
    
    
    675
    
    
    
    687
    
    
    
    
    
    
    
    Guaranteed minimum royalty obligation
    
    
    6,150
    
    
    
    3,400
    
    
    
    2,750
    
    
    
    
    
    
    
    Non-cancelable operating lease obligation
(net of subleases)
    
    
    11,921
    
    
    
    3,245
    
    
    
    6,623
    
    
    
    2,053
    
    
    
    Funding the purchase commitment to a
materials supplier
    
    
    4,056
    
    
    
    2,883
    
    
    
    1,173
    
    
    
    
    
    
    
    Funding the purchase of warehouse
Equipment
    
    
    1,891
    
    
    
    1,891
    
    
    
    
    
    
    
    
    
    
    
    Letters of credit
    
    
    4,241
    
    
    
    4,241
    
    
    
    
    
    
    
    
    
    
    
    Total contractual obligations
    
    $
    501,331
    
    
    $
    29,330
    
    
    $
    469,948
    
    
    $
    2,053
    
    
    $
    
 Long-term debt consists of borrowings under the New Senior Credit Facility
and Notes. The New Senior Credit Facility borrowings require quarterly
principal payments and the Notes require semi-annual interest payments. The
Company may, at its option, prepay the term loans without premium or penalty. The Company entered into several capital leases for warehouse equipment,
manufacturing equipment and office furniture and fixtures. The initial term of
the leases range from three years to seven years. Interest is imputed at a
weighted average rate of 6.47% per annum. In June of 2003, the Company entered into a twelve-year license agreement
(the License Agreement) with Meredith Corporation, of which, the first two
years are non-cancelable by either party. The agreement provides for earned
royalty payments to Meredith Corporation determined by a percentage of net
sales and guaranteed annual minimum royalty payments that escalate through the
term of the license agreement. In addition, in February 2004, the Company
entered into a two-year license agreement with The Thomas Kinkade Company (the
Licensor) that provides for earned royalty payments to the Licensor
determined by a percentage of net sales and guaranteed minimum royalty
payments. The Company has several outstanding operating leases related to the former
corporate headquarters facility and additional warehousing space. The majority
of the former corporate headquarters facility has been subleased. 28




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##### Table of Contents



The Company has entered into a two-year purchase agreement with a supplier
of raw materials used in production at its Laredo, Texas, manufacturing plant. The Company entered into an agreement to purchase and install a new
racking system used in order fulfillment located at the Carrollton, Texas,
distribution center. As of June 30, 2004, the Company had $4.2 million letters of credit
outstanding related to insurance policies. At June 30, 2004, the Company did not have any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes. As such, the Company is not
materially exposed to any financing, liquidity or market or credit risk that
could arise if the Company had engaged in such relationships. Market-Sensitive Instruments and Risk Management The Companys Products are sold in Mexico and Canada thereby subjecting
the Company to financial market risk due to fluctuating foreign currency
exchange rates. Historically, due to a stable foreign exchange and due to the
fact that these operations have not been significant, the risk has been minor.
However, as the Companys international operations become significant to the
Company as a whole, changes in foreign currency exchange rates could have a
material effect on the Company in the future. The Company has not entered into
any hedging instruments related to foreign currency risk. As a result of the interest pricing mechanism associated with the New
Senior Credit Facility, the Company is exposed to financial market risk due to
fluctuating interest rates. The Company monitors this risk and makes decisions
to participate in interest hedging devices based on interest rate expectations,
the Companys desire to maintain total yield within predetermined levels and
the ratio of fixed to variable debt. During the second quarter of 2004, the
Company finalized a series of interest rate swap agreements with a trade date
of May 5, 2004 and a start date of September 30, 2004, to limit the effect of
changes in interest rates on a portion of its long-term borrowings. Under the
trade agreement the Company pays on a quarterly basis a fixed interest rate per
quarter ranging from 1.91% to 5.18%. The agreement has a $100.0 million
notional amount of indebtedness. The Company receives a variable rate of
interest under the swaps based on the three-month London Inter-Bank Offer Rate
(LIBOR), excluding the margin paid under the credit facility on a quarterly
basis. The Company recognized an unrealized gain of approximately $0.09 million
in the consolidated statement of operations and comprehensive income for the
three months and six months ended June 30, 2004, related to the interest rate
swap agreement. The swap expires on September 28, 2007. The Company does not
use derivative instruments for trading or speculative purposes. The following table presents principal cash flows of variable rate debt by
maturity date and the related average interest rates, based upon existing terms
and does not take into account the impact of the interest rate swap agreement
mentioned above. The interest rates are estimated based on actual and implied
forward rates using a yield as of July 29, 2004. The Notes are at a fixed rate
of 10.125% and will mature in 2008. 29




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##### Table of Contents



Expected Maturity Date2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    Total
    
    Fair ValueVariable Rate
Debt
    
    $
    5,000
    
    
    $
    13,750
    
    
    $
    15,000
    
    
    $
    283,750
    
    
    $
    
    
    
    $
    317,500
    
    
    $
    Average Interest
Rate
    
    
    5.84
    %
    
    
    7.32
    %
    
    
    8.45
    %
    
    
    9.02
    %
    
    
    
    
    
    
    
    
    
    
    Fixed-Rate Debt
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    149,100
    
    
    $
    149,100
    
    
    $
    146,864Interest Rate Rate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10.125
    %
    
    
    
    
    
    
    
 Inflation Although the Companys operations are affected by general economic trends,
inflation and changing prices did not have a material impact on the Companys
operations during the three months and six months ended June 30, 2003 and 2004. Adoption of Accounting Standards In April of 2004, the Financial Accounting Standards Board, (FASB),
issued Staff Position Statement of Financial Accounting Standards No. 129-1,
Disclosure Requirements under FASB Statement No. 129, Disclosure of
Information about Capital Structure, Relating to Contingently Convertible
Securities (FSP FAS 129-1). FSP FAS 129-1 provides interpretation guidance
regarding the disclosure provisions of FASB Statement No. 129 as it applies to
contingently convertible securities and the potential dilutive effects on
earnings per share. FSP FAS 129-1 is effective as of April 9, 2004 and applies
to all existing and newly created securities. The Company has adopted FSP FAS
129-1 on April 9, 2004 and there was not a financial accounting nor disclosure
impact associated with its adoption. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Securities and Exchange Commission requires that registrants include
information about potential effects of changes in interest rates and currency
exchange on their financial statements. Refer to the information appearing
under the subheading Market-Sensitive Instruments and Risk Management under
Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operation, which information is hereby incorporated by reference
into this Item 3. All statements other than historical information incorporated
into this Item 3 are forward-looking statements. The actual impact of future
market changes could differ materially due to, among other things, the factors
discussed in this report. 
 ITEM 4. CONTROLS AND PROCEDURES Based on their evaluation of the Companys disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the Exchange Act)), the Companys principal
executive and principal financial officers concluded that the Companys
disclosure controls and procedures were effective as of June 30, 2004. There has been no change in the Companys internal control over financial
reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)
that occurred during the Companys fiscal quarter ended June 30, 2004, that has
materially affected, or is reasonably likely to materially affect, the
Companys internal control over financial reporting. 30




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##### Table of Contents



PART II OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS In the ordinary course of its business, the Company is from time to time
threatened with or named as a defendant in various lawsuits, including product
liability claims. The Company is also subject to certain environmental
proceedings. The Company is not currently a party to any material litigation or
proceeding, and is not aware of any litigation or proceeding threatened against
it that could have a material adverse effect on the Companys business,
financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On March 29, 2004 pursuant to a written consent of a majority of the
shareholders in lieu of a special meeting, Michael D. Kelly was elected as a
member of the board of directors of the Company. 
 ITEM 5. OTHER INFORMATION On June 25, 2004, Joe Colonnetta was elected to serve as Chairman of the
Board of Directors of the Company, a position previously held by Donald J.
Carter, Jr. until May 31, 2004 when Mr. Carter resigned from this position.
Mr. Colonnetta has been a Director of the Company since August 1999 and is a
Partner of Hicks, Muse, Tate & Furst Incorporated. Prior to joining Hicks Muse,
Mr. Colonnetta served as a Managing Principal of a management affiliate of
Hicks Muse from 1995 to 1998. Mr. Colonnetta has served in various Executive
Positions of consumer and industrial companies owned by Bass Investment
Partners and Oppenheimer & Company. Mr. Colonnetta is also a Director of Swift
& Company, Viasystems Group, Inc., Grupo Minsa, S.A., and Zilog Inc. 31




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##### Table of Contents



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS EXHIBITNUMBER
    
    DESCRIPTION10.1*
    
    Employment and Non-Compete Agreement Credit Agreement, effective
as of January 1, 2004, between Home Interiors & Gifts, Inc., a
Texas corporation and Mary-Knight Tyler.10.2*
    
    Executive Employment Agreement, executed June 23, 2004, to be
effective as of January 1, 2004, made and entered into by and
between Home Interiors & Gifts, Inc., a Texas corporation and
Michael D. Lohner.10.3*
    
    Letter of agreement referencing to Executive Employment Agreement,
dated as of June 23, 2004, by and between Home Interiors & Gifts,
Inc., a Texas corporation and Michael D. Lohner.10.4*
    
    Confidential Separation Agreement and Release between Charles L.
Elsey and Domistyle, Inc. effective as of April 30, 2004.31.1*
    
    Certification of Chief Executive Officer of the Company pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.31.2*
    
    Certification of Chief Financial Officer of the Company pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.32.1*
    
    Certification of Chief Executive Officer of the Company pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.32.2*
    
    Certification of Chief Financial Officer of the Company pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
   *Filed herewith. 32




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized. HOME INTERIORS & GIFTS, INC.By:
    
    /s/ KENNETH J. CICHOCKIKenneth J. CichockiSr. Vice President of Finance and Chief Financial Officer(principal financial and accounting officer)
 Date: August 12, 2004 33




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##### Table of Contents



EXHIBIT INDEX EXHIBITNUMBER
    
    DESCRIPTION10.1*
    
    Employment and Non-Compete Agreement Credit Agreement, effective
as of January 1, 2004, between Home Interiors & Gifts, Inc., a
Texas corporation and Mary-Knight Tyler.10.2*
    
    Executive Employment Agreement, executed June 23, 2004, to be
effective as of January 1, 2004, made and entered into by and
between Home Interiors & Gifts, Inc., a Texas corporation and
Michael D. Lohner.10.3*
    
    Letter of agreement referencing to Executive Employment Agreement,
dated as of June 23, 2004, by and between Home Interiors & Gifts,
Inc., a Texas corporation and Michael D. Lohner.10.4*
    
    Confidential Separation Agreement and Release between Charles L.
Elsey and Domistyle, Inc. effective as of April 30, 2004.31.1*
    
    Certification of Chief Executive Officer of the Company pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.31.2*
    
    Certification of Chief Financial Officer of the Company pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.32.1*
    
    Certification of Chief Executive Officer of the Company pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.32.2*
    
    Certification of Chief Financial Officer of the Company pursuant
to Section 906 of the Sarbanes-Oxley Act of 2002.
   *Filed herewith. 34