UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 25, 2005
or
For the transition period from to
Commission File Number: 0-20242
CENTRAL GARDEN & PET COMPANY
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification No.)
1340 Treat Blvd., Suite 600, Walnut Creek, California 94597
(Address of principle executive offices)
(925) 948-4000
(Registrant’s telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)
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. xYes ¨ No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). x Yes ¨ No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common Stock Outstanding as of July 22, 2005
Class B Stock Outstanding as of July 22, 2005
Item 1.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995.
This Form 10-Q includes “forward-looking statements.” Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, future revenues or performance, capital expenditures, financing needs, plans or intentions relating to acquisitions, our competitive strengths and weaknesses, our business strategy and the trends we anticipate in the industries and economies in which we operate and other information that is not historical information. When used in this Form 10-Q, the words “estimates,” “expects,” “anticipates,” “projects,” “plans,” “intends,” “believes” and variations of such words or similar expressions are intended to identify forward-looking statements. All forward-looking statements, including, without limitation, our examination of historical operating trends, are based upon our current expectations and various assumptions. Our expectations, beliefs and projections are expressed in good faith, and we believe there is a reasonable basis for them, but we cannot assure you that our expectations, beliefs and projections will be realized.
There are a number of risks and uncertainties that could cause our actual results to differ materially from the forward-looking statements contained in this Form 10-Q. Important factors that could cause our actual results to differ materially from the forward-looking statements we make in this Form 10-Q are set forth in our Form 10-K for the fiscal year ended September 25, 2004, including the factors described in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Risk Factors.” If any of these risks or uncertainties materialize, or if any of our underlying assumptions are incorrect, our actual results may differ significantly from the results that we express in or imply by any of our forward-looking statements. We do not undertake any obligation to revise these forward-looking statements to reflect future events or circumstances. Presently known risk factors include, but are not limited to, the following factors:
2
PART I. FINANCIAL INFORMATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
(unaudited)
September 25,
2004
June 25,
2005
Current assets:
Cash and equivalents
Restricted investments
Accounts receivable (less allowance for doubtful accounts of $12,348 and $11,238 )
Inventories
Prepaid expenses and other
Total current assets
Land, buildings, improvements and equipment—net
Goodwill
Deferred income taxes and other assets
Total
Current liabilities:
Accounts payable
Accrued expenses
Current portion of long-term debt
Total current liabilities
Long-term debt
Other long-term obligations
Convertible redeemable preferred stock
Shareholders’ equity:
Class B stock, $.01 par value: 1,654,462 shares outstanding
Common stock, $.01 par value: 32,515,220 and 33,055,020 shares issued and 18,772,970 and 19,299,811 shares outstanding at September 25, 2004 and June 25, 2005
Additional paid-in capital
Retained earnings
Deferred compensation
Treasury stock
Accumulated other comprehensive income
Total shareholders’ equity
See notes to condensed consolidated financial statements.
3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
June 26,
Net sales
Cost of goods sold and occupancy
Gross profit
Selling, general and administrative expenses
Income from operations
Interest expense
Interest income
Other income
Income before income taxes
Income taxes
Net income
Income per common share:
Basic
Diluted
Weighted average shares used in the computation of income per common share:
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization
Amortization of deferred compensation
Change in assets and liabilities (excluding effects of businesses acquired):
Receivables
Prepaid expenses and other assets
Net cash provided by operating activities
Cash flows from investing activities:
Additions to land, buildings, improvements and equipment
Businesses acquired, net of cash acquired
Net cash used in investing activities
Cash flows from financing activities:
Repayments on revolving line of credit
Borrowings on revolving line of credit
Proceeds from issuance of long-term debt
Repayments of long-term debt
Proceeds from issuance of stock
Treasury stock repurchases
Net cash provided by financing activities
Effect of exchange rate changes on cash and equivalents
Net decrease in cash and equivalents
Cash and equivalents at beginning of period
Cash and equivalents at end of period
Supplemental information:
Cash paid for interest
Cash paid for income taxes—net
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Nine Months Ended June 25, 2005
The condensed consolidated balance sheets of Central Garden & Pet Company and subsidiaries (the “Company” or “Central”) as of June 25, 2005, the condensed consolidated statements of operations for the three and nine months ended June 26, 2004 and June 25, 2005 and the condensed consolidated statements of cash flows for the nine months ended June 26, 2004 and June 25, 2005 have been prepared by the Company, without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) considered necessary to present fairly the financial position, results of operations and cash flows of the Company for the periods mentioned above, have been made.
For the Company’s foreign business in the UK, the local currency is the functional currency. Assets and liabilities are translated using the exchange rate in effect at the balance sheet date. Income and expenses are translated at the average exchange rate for the period. Comprehensive income was $47.6 million for the nine month period ended June 25, 2005 and includes net earnings of $47.1 million and foreign currency translation adjustments of $0.5 million that are excluded from net earnings but reported in accumulated other comprehensive income, a separate component of shareholders’ equity. Deferred taxes are not provided on translation gains and losses, because the Company expects earnings of its foreign subsidiary to be permanently reinvested. Transaction gains and losses are included in results of operations.
Due to the seasonal nature of the Company’s garden business, the results of operations for the three and nine months ended June 25, 2005 are not indicative of the operating results that may be expected for the entire fiscal year. These interim financial statements should be read in conjunction with the annual audited financial statements, accounting policies and financial notes thereto, included in the Company’s 2004 Annual Report on Form 10-K, which has previously been filed with the Securities and Exchange Commission.
The Company has various non-qualified stock-based compensation programs, which provide for stock option grants and restricted stock awards. The fair value of restricted stock awards is recognized as deferred compensation at the time of the grant as a separate component of shareholders’ equity with amortization over the vesting period. Stock options may be granted to officers, key employees and directors. The Company has elected to continue to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby the options are granted at market price, and, therefore, no compensation expenses are recognized. As required by Statement of Financial Accounting Standards No. 148 (SFAS No. 148), Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123, the Company has provided fair value based pro-forma disclosures in its interim financial statements.
If compensation expense for the Company’s various stock option plans had been determined based upon the projected fair values at the grant dates for awards under those plans in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, the Company’s pro-forma net earnings, basic and diluted earnings per common share would have been as follows:
Net income, as reported
Deduct: Total stock-based employee compensation expense determined under fair value based method for awards, net of related tax effects
Pro forma net income
Net income per common equivalent share:
Basic – as reported
Basic – pro forma
Diluted – as reported
Diluted – pro forma
6
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. The statement supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123R requires all entities to recognize compensation expense in an amount equal to the fair-value of share-based payments. Upon adoption at the beginning of our next fiscal year, all employee stock option awards will be recognized as an expense in the Company’s statement of operations, typically over the related vesting period of the options. SFAS No. 123R requires use of fair value to measure share-based awards issued to employees, computed at the date of grant. Additionally, SFAS No. 123R requires companies to record compensation expense for the unvested portion of previously granted awards as they continue to vest, as calculated previously and included in the Company’s prior pro forma disclosures under SFAS No. 148.
The Company will adopt SFAS No. 123R at the beginning of fiscal year 2006, as required, and will adopt the standard using the modified prospective method requiring the Company to record compensation expense for all awards granted after the date of adoption, and for the unvested portion of previously granted awards outstanding as of the date of adoption.
The following is a reconciliation of the numerators and denominators of the basic and diluted per share computations for income from continuing operations:
Three Months Ended
June 25, 2005
Nine Months Ended
Basic EPS:
Effect of dilutive securities:
Options to purchase common stock
Restricted shares
Convertible preferred stock
Diluted EPS:
Net income attributable to common shareholders
June 26, 2004
Options to purchase 1,873,103 shares of common stock at prices ranging from $7.54 to $48.14 per share were outstanding at June 25, 2005 and options to purchase 2,238,380 shares of common stock at prices ranging from $1.30 to $38.41 per share were outstanding at June 26, 2004. For the three month periods ended June 25, 2005 and June 26, 2004, options to purchase 7,800 and 7,500 shares of common stock, respectively, were outstanding but were not included in the computation of diluted earnings per share because the option exercise prices were greater than the average market price of the common shares and, therefore, the effect would be anti-dilutive. For the nine month periods ended June 25, 2005 and June 26, 2004, options to purchase 30,680 and 52,310 shares of common stock, respectively, were outstanding but were not included in the computation of diluted earnings per share because the option exercise prices were greater than the average market price of the common shares and, therefore, the effect would be anti-dilutive.
Shares of common stock from the assumed conversion of the Company’s convertible preferred stock, issued in February 2004, were also included in the computation of diluted EPS for the three and nine month periods ended June 25, 2005, and June 26, 2004.
7
In May 2005, the Company acquired Pets International, Ltd., for approximately $35 million in cash, with possible contingent performance based payments over the next seven months. Pets International is a leading supplier of innovative small animal and specialty pet supplies including homes, habitats, exercise toys, feeding devices, chews and other care and maintenance products marketed under the proprietary brand name “Super Pet®.” The Company has not yet finalized its allocation of the purchase price to the fair value of assets acquired. The consolidated financial statements include the operating results of Pets International, Ltd. from the date of acquisition.
In April 2005, the Company acquired the remaining 60% of Cedar Works, LLC (“Cedar Works”), for approximately $4.5 million in cash. The Company previously acquired its 40% interest in November 1999 which had been accounted for as an equity method investment. Cedar Works is primarily engaged in the manufacture and sale of bird feeders, bird homes and mailboxes. The Company has not yet finalized its allocation of the purchase price to the fair value of assets acquired. The consolidated financial statements include the operating results of Cedar Works from the date of acquisition.
In February 2005, the Company acquired Gulfstream Home & Garden, Inc. (“Gulfstream”), including its 20% equity interest in Tech Pac, LLC (“Tech Pac”), for approximately $21 million in cash, with possible contingent performance based payments over the next ten years. Gulfstream is the exclusive marketer of the garden product brands Sevin(R), Over’n Out!(R), and RooTone(R) through its relationship with Tech Pac, a supplier of insect control products. The Company has not yet finalized its allocation of the purchase price to the fair value of assets acquired. The consolidated financial statements include the results of Gulfstream from the date of acquisition.
Management has determined that the reportable segments of the Company are Garden Products and Pet Products, based on the level at which the chief operating decision making group reviews the results of operations to make decisions regarding performance assessment and resource allocation.
Net sales:
Garden Products
Pet Products
Total net sales
Income from operations:
Corporate
Total income from operations
Interest expense—net
Depreciation and amortization:
Total depreciation and amortization
8
Assets:
Total assets
Goodwill (included in corporate assets):
Total goodwill
Central does not believe that the outcome of the following legal proceedings will have a material adverse effect on its results of operations, liquidity or financial position taken as a whole. However, because these proceedings may raise complex factual and legal issues and are subject to uncertainties, Central cannot predict with assurance the outcome of these proceedings. Accordingly, adverse settlements or resolutions may occur and negatively impact earnings or cash flows in the quarter of settlement or resolution.
TFH Litigation. In December 1997, Central acquired all of the stock of TFH Publications, Inc. (“TFH”). In connection with the transaction, Central made a $10 million loan to the sellers (the “Axelrod Loan”), which was evidenced by a Promissory Note. In September 1998, the prior owners of TFH brought suit against Central and certain executives of Central for damages and relief from their obligations under the Promissory Note, alleging, among other things, that Central’s failure to properly supervise the TFH management team had jeopardized their prospects of achieving certain earnouts. Central believes that these allegations are without merit. Central counterclaimed against the prior owners for enforcement of the Promissory Note, rescission and/or damages and other relief, alleging, among other things, fraud, misrepresentation and breach of fiduciary duty by the prior owners of TFH. These actions, Herbert R. Axelrod and Evelyn Axelrod v. Central Garden & Pet Company; Glen S. Axelrod; Gary Hersch; William E. Brown; Robert B. Jones; Glenn Novotny; and Neill Hines, Docket No. MON-L-5100-99, and TFH Publications, Inc. v. Herbert Axelrod et al., Docket No. L-2127-99 (consolidated cases), are in the New Jersey Superior Court. The trial in this matter began on April 4, 2005 and is currently ongoing.
During the course of discovery in this action, Central became aware of certain information which shows that prior to the acquisition of TFH by Central, certain records of TFH were prepared in an inaccurate manner which, among other things, resulted in underpayment of taxes by certain individuals. Those individuals could be liable for back taxes, interest, and penalties. In addition, even though all of the events occurred prior to the acquisition of TFH by Central, there is a possibility that TFH could be liable for penalties for events which occurred under prior management. Central believes that TFH has strong defenses available to the assertion of any penalties against TFH. Central cannot predict whether TFH will be required to pay any such penalties. In the event that TFH were required to pay penalties, Central would seek compensation from the prior owners.
On April 12, 2004, one of the former owners of TFH, Herbert Axelrod, was indicted by a federal grand jury. The two-count federal indictment, which was based on actions taken by Herbert Axelrod before Central acquired TFH, charged Herbert Axelrod with conspiracy to defraud the United States Internal Revenue Service and aiding and abetting the filing of false tax returns by a former Vice President of TFH. In April 2004, Herbert Axelrod failed to appear for his arraignment, and a federal warrant was issued for his arrest. Subsequently, Herbert Axelrod was arrested in Germany and extradited to the United States. In December 2004, Herbert Axelrod pled guilty to a criminal charge of aiding and abetting the filing of a false income tax return. Herbert Axelrod is currently serving his sentence in jail for this crime. Central has information that Herbert Axelrod has liquidated and transferred assets out of the United States. The status of his assets has raised questions, which cannot presently be answered, about Central’s ability to collect on any of its claims against Herbert Axelrod or the Axelrod Loan. Central intends to continue pursuing its claims against Mr. Axelrod. If Central is unsuccessful in its claims against Mr. Axelrod regarding the Axelrod Loan or is unable to collect any judgment awarded, Central would be required to write off the Axelrod Loan, which would result in a non-cash charge against its future earnings. The Axelrod Loan of $10.2 million is included in Other Assets in the consolidated financial statements of Central.
Scotts Litigation. On June 30, 2000, The Scotts Company filed suit against Central to collect the purchase price of certain lawn and garden products previously sold to Central. See The Scotts Company v. Central Garden & Pet Company, Docket No. C2 00-755 (U.S. Dist Ct. N.D. Ohio). Central filed its answer and a counter complaint asserting various claims for breaches of contracts.
In April 2002, trial occurred on the claims and counterclaims of the parties (excluding one oral contract claim that was severed from the remainder of the case). The net verdict was in favor of Scotts in the amount of $10.4 million which had previously been recorded as an obligation by the Company. Scotts and Central filed post-trial motions. In a March 20, 2003 order, the district court denied Scotts’ motion for attorneys’ fees, granted Scotts’ motion to set aside $750,000 of the jury amount awarded to Central, denied Central’s motion for a new trial, granted Central’s motion for prejudgment interest, and granted in part and denied in part Scotts’ motion for prejudgment interest. The court directed each party to re-determine the amount of their respective interest claims in light of the Court’s ruling and to submit their respective determinations. On July 11, 2003, the Court issued an order resolving the remaining
9
prejudgment interest issues and directing the parties to submit calculations in accordance with its decision. Pursuant to this order, the Court awarded prejudgment interest to Scotts in the net amount of $2.8 million. On October 3, 2003, Central and Scotts settled the oral contract claim that had previously been severed from the remainder of the case. Pursuant to the settlement, Scotts reduced the judgment amount by $300,000. Central and Scotts appealed different aspects of the prior judgment and post-judgment orders. In connection with the appeal, Central paid approximately $15 million into an escrow account, which is reported as restricted investments in the accompanying balance sheets as of September 25, 2004 and June 25, 2005. On April 12, 2005, the Sixth Circuit Court of Appeals issued its decision affirming the district court’s decisions on all but two issues. The Sixth Circuit determined that the district court had erred in allowing Scotts to recover prejudgment interest at 18% rather than 10% as to a portion of its claim. The Sixth Circuit also ruled that prejudgment interest accrued to the date of the revised judgment filed in September 2003 rather than the original judgment entered in May 2002. The case was remanded back to the district court for redetermination of the interest amount. In July 2005, the Company and Scotts reached agreement on the amount due, and all litigation with Scotts has now been resolved. The award amount has been paid to Scotts from the escrow proceeds which are reported as restricted investments in the accompanying balance sheets as of September 25, 2004 and June 25, 2005. This settlement was provided for in prior years and had no impact on current results.
Phoenix Fire. On August 2, 2000, a fire destroyed Central’s leased warehouse space in Phoenix, Arizona, and an adjoining warehouse space leased by a third party. On July 31, 2001, the adjoining warehouse tenant filed a lawsuit against Central and other parties in the Superior Court of Arizona, Maricopa County, seeking to recover $47 million for property damage from the fire. See Cardinal Health Inc., et al. v. Central Garden & Pet Company, et al., Civil Case No. CV2001-013152. Local residents also filed a purported class action lawsuit alleging claims for bodily injury and property damage as a result of the fire. This class action lawsuit has now been settled as to all parties, and has received Court approval. As part of the settlement, Central’s liability insurers paid $7,825,000 on behalf of Central in May 2004. The building owner and several nearby businesses have also filed lawsuits for property damage and business interruption, which are being coordinated with the remaining tenant lawsuit. Each of these lawsuits is currently pending in the Superior Court of Arizona, Maricopa County. The trial for the remaining cases is currently scheduled for March 2006. Four of the business interruption lawsuits have been settled for amounts totaling approximately $680,000, paid by Central’s insurers. The overall amount of the damages to all parties caused by the fire, and the overall amount of damages which Central may sustain as a result of the fire, have not been quantified. At the time of the fire, Central maintained property insurance covering losses to the leased premises, Central’s inventory and equipment, and loss of business income. Central also maintained insurance providing $51 million of coverage (with no deductible) against third party liability. Central believes that this insurance coverage will be available with respect to third party claims against Central if parties other than Central are not found responsible. The precise amount of the damages sustained in the fire, the ultimate determination of the parties responsible and the availability of insurance coverage are likely to depend on the outcome of complex litigation, involving numerous claimants, defendants and insurance companies.
Certain wholly owned subsidiaries of the Company (as listed below, collectively the “Guarantor Subsidiaries”) have guaranteed fully and unconditionally, on a joint and several basis, the obligation to pay principal and interest under the Company’s $150,000,000 9-1/8% Senior Subordinated Notes (the “Notes”) issued on January 30, 2003. Certain subsidiaries and operating divisions are not guarantors of the Notes and have been included in the Parent financial results below. Those subsidiaries that are guarantors of the Notes are as follows:
Four Paws Products Ltd.
Grant Laboratories, Inc.
Gulfstream Home & Garden, Inc.
Interpet USA, LLC
Kaytee Products, Incorporated
Matthews Redwood & Nursery Supply, Inc.
New England Pottery LLC
Norcal Pottery Products, Inc.
Pennington Seed, Inc. (including Phaeton Corporation (dba Unicorn Labs), Pennington Seed, Inc. of Nebraska, Gro Tec, Inc., Seeds West, Inc., All-Glass Aquarium Co., Inc. (including Oceanic Systems, Inc.), Cedar Works, LLC.)
Pets International, Ltd.
T.F.H. Publications, Inc.
Wellmark International
In lieu of providing separate unaudited financial statements for the Guarantor Subsidiaries, the Company has included the accompanying unaudited condensed consolidating financial statements based on the Company’s understanding of the Securities and Exchange Commission’s interpretation and application of Rule 3-10 of the Securities and Exchange Commission’s Regulation S-X.
10
CONSOLIDATING CONDENSED STATEMENT OFOPERATIONS
Three Months Ended June 25, 2005
Guarantor
Subsidiaries
Cost of products sold and occupancy
Interest – net
Equity in undistributed income of guarantor subsidiaries
Net income (loss)
Three Months Ended June 26, 2004
Income (loss) before income taxes
11
Nine Months Ended June 25, 2005
Other income (expense)
Nine Months Ended June 26, 2004
Income (loss) from operations
12
Accounts receivable
Land, buildings, improvements and equipment, net
Investment in guarantor subsidiaries
Accrued expenses and other current liabilities
Shareholders’ equity
13
CONSOLIDATING CONDENSED STATEMENT OFCASH FLOWS
Nine Months Ended June 25, 2005(in thousands)
Net cash provided (used) by operating activities
Expenditures for land, buildings, improvements and equipment
Businesses acquired
Investments
Net cash provided (used) by investing activities
Payments on long-term debt
Payments to reacquire stock
Effect of exchange rates on cash
Net increase (decrease) in cash and equivalents
Proceeds from long-term debt
Net cash provided (used) by financing activities
14
Overview
Central Garden & Pet Company is a leading innovator, marketer and producer of quality branded products for the pet and lawn and garden supplies markets. We are one of the largest companies in the fragmented, $7.5 billion U.S. pet supplies industry and in the $50 billion U.S. lawn and garden and related supplies industry. Our pet products include pet bird and small animal food, aquarium products, flea, tick, mosquito and other insect control products, edible bones, cages, carriers, pet books, and other dog, cat, reptile and small animal products. These products are sold under a number of brand names, including Super Pet, Kaytee, All-Glass Aquarium, Oceanic, Zodiac, Pre-Strike, Altosid, Nylabone, TFH, Four Paws, Kent Marine, Interpet and Energy Savers Unlimited. Our lawn and garden products include grass seed, wild bird food, weed and insect control products, decorative outdoor patio products, Christmas products and lighting and ant control products. These products are sold under a number of brand names, including Pennington, Norcal Pottery, New England Pottery, GKI/Bethlehem Lighting, Lilly Miller, Matthews Four Seasons, AMDRO and Grant’s. In fiscal 2004, consolidated net sales were $1.27 billion, of which our pet products segment, or Pet Products, accounted for $568.9 million and our lawn and garden products segment, or Garden Products, accounted for $697.5 million. In fiscal 2004, income from operations was $82.1 million, of which Pet Products accounted for $61.4 million and Garden Products accounted for $42.9 million, before corporate expenses and eliminations of $22.2 million.
Central was incorporated in Delaware in June 1992 and is the successor to a California corporation which was incorporated in 1955. References to “we,” “us,” “our,” or “Central” mean Central Garden & Pet Company and its subsidiaries and divisions, and their predecessor companies and subsidiaries.
Background
We transitioned our company to a leading marketer and producer of branded products from a traditional pet and lawn and garden supplies distributor. We made this transition because we recognized the opportunity to build a portfolio of leading brands and improve profitability by capitalizing on our knowledge of the pet and lawn and garden supplies sectors, our strong relationships with retailers, and our nationwide sales and logistics network. Our goal was to diversify our business and improve operating margins by establishing a portfolio of leading brands. Since 1997, we have acquired numerous branded products companies and product lines, including Wellmark and Four Paws in fiscal 1997; Kaytee Products, TFH and Pennington Seed in fiscal 1998; Norcal Pottery in fiscal 1999; AMDRO and All-Glass Aquarium in fiscal 2000; Lilly Miller in fiscal 2001; Alaska Fish Fertilizer in fiscal 2002; Kent Marine, New England Pottery, Interpet, KRB Seed Company (dba Budd Seed), and Energy Savers Unlimited in fiscal 2004.
While expanding our branded products business, we experienced adverse events in our distribution business. From 1995 to 1999, we were the master distributor of Round Up and Ortho. In January 1999, The Scotts Company, one of our largest distribution suppliers at the time, acquired Ortho and became the marketing agent for Round Up. In July 2000, Scotts terminated its relationship with us. Subsequently, we downsized our distribution operations and integrated these sales and logistics networks into our pet and lawn and garden products businesses to allow us to focus resources and provide strategic sales support for our brands.
Virtually all of our sales before fiscal 1997 were from distributing other manufacturers’ products. Since then, our branded product sales have grown to approximately $959 million, or approximately 76% of total sales, in fiscal 2004. During this same period, our sales of other manufacturers’ products have declined to approximately 24% of total sales, and our gross profit margins have improved from 13.6% in fiscal 1996 to 30.3% in fiscal 2004.
Recent Developments
Acquisition of Pets International
In May 2005, the Company acquired Pets International, Ltd., for approximately $35 million in cash, with possible contingent performance based payments over the next seven months. Pets International is a leading supplier of innovative small animal and specialty pet supplies including homes, habitats, exercise toys, feeding devices, chews and other care and maintenance products marketed under the proprietary brand name “Super Pet®.” The consolidated financial statements include the operating results of Pets International, Ltd. from the date of acquisition.
Acquisition of Cedar Works
In April 2005, the Company acquired the remaining 60% of Cedar Works, LLC, for approximately $4.5 million in cash. The Company previously acquired its 40% interest in November 1999 which had been accounted for as an equity method investment. Cedar Works is primarily engaged in the manufacture and sale of bird feeders, bird homes and mailboxes. The consolidated financial statements include the operating results of Cedar Works from the date of acquisition.
15
Acquisition of Gulfstream
In February 2005, the Company acquired Gulfstream Home & Garden, Inc. (“Gulfstream”), including its 20% equity interest in Tech Pac, L.L.C. (“Tech Pac”), for approximately $21 million in cash, with possible contingent performance based payments over the next ten years. Gulfstream is the exclusive marketer of the garden product brands Sevin(R), Over’n Out!(R), and RooTone(R) through its relationship with Tech Pac, a supplier of insect control products. The consolidated financial statements include the results of Gulfstream from the date of acquisition.
Scott’s Payment
In July 2005 the Company and Scotts reached agreement on the amount due and all litigation with Scotts has now been resolved. The award amount has been paid to Scotts from the escrow proceeds which are reported as restricted investments in the accompanying balance sheets as of September 25, 2004 and June 25, 2005. This settlement was provided for in prior years and had no impact on current results.
New Accounting Pronouncements
Accounting for Stock-Based Compensation
We currently measure compensation expense for our employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and provide pro forma disclosures of the effect on net income and earnings per share as if the fair value-based method had been applied in measuring compensation expense. We have elected to follow APB Opinion No. 25 because the alternative fair value accounting provided for under SFAS No. 123, Accounting for Stock-Based Compensation, requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB Opinion No. 25, when the exercise price of our employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. The statement supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123R requires all entities to recognize compensation expense in an amount equal to the fair-value of share-based payments. Upon adoption, all employee stock option awards will be recognized as an expense in our statement of operations, typically, over the related vesting period of the options. SFAS No. 123R requires use of fair value to measure share-based awards issued to employees, computed at the date of grant. Additionally, SFAS No. 123R requires companies to record compensation expense for the unvested portion of previously granted awards as they continue to vest, as calculated previously and included in the Company’s prior period pro forma disclosures under SFAS No. 148.
SFAS 123R was originally effective for reporting periods that began after June 15, 2005. In April 2005, the SEC announced the adoption of a new rule allowing companies to implement SFAS 123R at the beginning of their next fiscal year that begins after June 15, 2005. We will adopt SFAS No. 123R effective September 25, 2005, as required, and will adopt the standard using the modified prospective method requiring us to record compensation expense for all awards granted after the date of adoption, and for the unvested portion of previously granted awards outstanding as of the date of adoption.
We will recognize substantially more compensation expense in future periods as a result of adopting SFAS No. 123R and expensing the calculated fair value of employee stock options. Based on employee stock options outstanding at June 25, 2005, we will record additional compensation expense of approximately $2 million, impacting fully diluted earnings per share by approximately $0.07 per share for the 2006 fiscal year. Grants subsequent to June 25, 2005 and during fiscal 2006 would have further impact on fully diluted earnings per share.
Exchanges of Nonmonetary Assets
In December 2004, the FASB issued SFAS 153, Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29 (SFAS 153). The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. The guidance in APB Opinion No. 29, however, included certain exceptions to that principle. SFAS 153 amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for nonmonetary asset exchanges in fiscal periods beginning after June 15, 2005. We do not believe that the adoption of SFAS 153 will have a material impact on our results of operations or financial position.
Critical Accounting Policies, Estimates and Judgments
There have been no material changes to our critical accounting policies, estimates and assumptions or the judgments affecting the application of those accounting policies since our Annual Report on Form 10-K for the fiscal year ended September 25, 2004.
16
Results of Operations
Compared with Three Months Ended June 26, 2004
Net sales for the three months ended June 25, 2005 increased $38.8 million, or 10.4%, to $413.2 million from $374.4 million for the three months ended June 26, 2004. Pet Products’ net sales increased $17.5 million, or 12.0%, to $163.4 million for the three months ended June 25, 2005 from $145.9 million in the comparable fiscal 2004 period. Garden Products’ net sales increased $21.3 million, or 9.3%, to $249.8 million for the three months ended June 25, 2005 from $228.5 million in the comparable fiscal 2004 period. Our branded product sales increased $37.3 million and sales of other manufacturers’ products increased $1.5 million. Our Pet Products’ branded product sales increased $14.3 million of which $6.6 million was from recent acquisitions and the remainder representing organic growth. Our Garden Products’ branded product sales increased $23.0 million due primarily to increased organic sales and $5.9 million from fiscal year 2005 acquisitions.
Gross profit for the three months ended June 25, 2005 increased $12.3 million, or 10.4%, to $130.2 million from $117.9 million for the three months ended June 26, 2004. Gross profit increased $3.3 million in Garden Products and $9.0 million in Pet Products. The improvements were due primarily to contributions from acquisitions in the past year of approximately $5 million, sales of branded products and improvement in our grass seed operations. Gross profit as a percentage of net sales was 31.5% for the three months ended June 25, 2005 and for the three months ended June 26, 2004.
Selling, general and administrative expenses increased $5.8 million, or 6.8%, from $86.2 million for the three months ended June 26, 2004 to $92.0 million for the three months ended June 25, 2005. As a percentage of net sales, selling, general and administrative expenses decreased to 22.3% for the three months ended June 25, 2005, compared to 23.0% in the comparable prior year period.
Selling and delivery expenses increased $2.2 million, or 4.5%, from $49.0 million for the three months ended June 26, 2004 to $51.2 million for the three months ended June 25, 2005. The increase was primarily attributable to $1.5 million from acquisitions and from increased common carrier charges and increased fuel charges.
Facilities expense remained relatively flat, decreasing $0.1 million to $2.8 million for the three months ended June 25, 2005 from $2.9 million for the three months ended June 26, 2004.
Warehouse and administrative expenses increased $3.7 million, or 10.8%, from $34.3 million for the three months ended June 26, 2004 to $38.0 million for the three months ended June 25, 2005. The increase was primarily related to professional fees for litigation of $2.4 million and Sarbanes-Oxley compliance of $1.3 million.
Net interest expense for the three months ended June 25, 2005 increased $1.1 million, or 23.3%, to $6.0 million from $4.9 million for the three months ended June 26, 2004. The increase was due primarily to increased average long-term debt balances during the fiscal 2005 quarter as compared to the prior year quarter, as a result of acquisitions made subsequent to the third quarter of fiscal 2004, and slightly higher interest rates on our floating rate debt.
Other income increased $1.2 million to $2.9 million for the quarter ended June 25, 2005 from $1.7 million for the quarter ended June 26, 2004. Other income represents income from equity method investments. An equity investment acquired in fiscal 2005 contributed $0.5 million of the increase. The remaining previously held equity investments also experienced more favorable results in the current quarter.
Our effective income tax rate for the quarter ended June 25, 2005 was 36.9% compared with 37.1% for the quarter ended June 26, 2004. The effective income tax rate is for the current quarter only and is not reflective of the rate applicable to the Company for the full fiscal year 2005. The effective tax rate was lower in the third quarter due to a one-time net tax benefit resulting from the favorable resolution of various tax issues plus the additional recognition of tax credits.
17
Compared with Nine Months Ended June 26, 2004
Net sales for the nine months ended June 25, 2005 increased $101.8 million, or 10.7%, to $1,057.6 million from $955.8 million for the nine months ended June 26, 2004. Pet Products’ net sales increased $58.2 million, or 13.8%, to $478.6 million for the nine months ended June 25, 2005 from $420.4 million in the comparable fiscal 2004 period. Garden Products’ net sales increased $43.6 million, or 8.2%, to $579.0 million for the nine months ended June 25, 2005 from $535.4 million in the comparable fiscal 2004 period. Our branded product sales increased $99.0 million and sales of other manufacturers’ products increased $2.8 million. Our Pet Products’ branded product sales increased $47.7 million of which approximately $33.8 million related to acquisitions and approximately $13.9 million related to increased organic brand sales. Our Garden Products’ branded product sales increased $51.4 of which $32.7 million related to acquisitions and approximately $18.8 million related to increased organic brand sales.
Gross profit for the nine months ended June 25, 2005 increased $51.2 million, or 17.5%, to $343.2 million from $292.0 million for the nine months ended June 26, 2004. Gross profit increased $16.7 million in Garden Products and $34.5 million in Pet Products. Gross profit as a percentage of net sales increased to 32.4% for the nine months ended June 25, 2005, from 30.6% for the nine months ended June 26, 2004, as both Garden Products’ and Pet Products’ margins improved. The margin improvements were due primarily to the contributions from our acquisitions of approximately $29 million, increased grass seed margins of approximately $3 million resulting from focusing on higher profit product and the resulting flow through of our organic sales increase.
Selling, general and administrative expenses increased $33.4 million, or 15.0%, from $222.4 million for the nine months ended June 26, 2004 to $255.8 million for the nine months ended June 25, 2005. As a percentage of net sales, selling, general and administrative expenses increased to 24.2% for the nine months ended June 25, 2005, compared to 23.3% in the comparable prior year period.
Selling and delivery expenses increased $18.3 million, or 16.0%, from $114.7 million for the nine months ended June 26, 2004 to $133.0 million for the nine months ended June 25, 2005. The increase was primarily attributable to $10 million from acquisitions subsequent to the third quarter of fiscal 2004 and increased common carrier and fuel costs.
Facilities expense remained relatively flat, increasing $0.3 million to $8.7 million for the nine months ended June 25, 2005 from $8.4 million for the nine months ended June 26, 2004.
Warehouse and administrative expenses increased $14.8 million, or 14.9%, from $99.3 million for the nine months ended June 26, 2004 to $114.1 million for the nine months ended June 25, 2005. Approximately $9 million of the increase was due to recent acquisitions and professional fees of $3.9 million related to Sarbanes-Oxley compliance and litigation.
Net interest expense for the nine months ended June 25, 2005 increased $3.6 million, or 27.4%, to $16.7 million from $13.1 million for the nine months ended June 26, 2004. The increase was due primarily to increased average total long-term debt balances during the fiscal 2005 period as compared to the prior year period, resulting from acquisitions that were made subsequent to the third quarter of fiscal 2004, and slightly higher interest rates on our floating rate debt.
Other income increased $2.7 million to $4.6 million for the nine months ended June 25, 2005 from $1.9 million for the nine months ended June 26, 2004. Other income represents income from equity method investments. While our investments performed better in the current year, the majority of the increase was related to one of our equity method investments being positively impacted by sales in the current fiscal year, originally expected in the next fiscal year, due to a change in the buying pattern of a customer. As such, it is possible there will be no earnings in fiscal year 2006 from this investment.
Our effective income tax rate for the nine months ended June 25, 2005 was 37.5% compared with 38.2% for the nine months ended June 26, 2004. The lower rate reflects a one-time net tax benefit and additional tax credits recognized in the fiscal quarter ended June 25, 2005 and the impact of non-US tax rates at our U.K. based subsidiary.
18
Liquidity and Capital Resources
We have financed our growth through a combination of bank borrowings, supplier credit, internally generated funds and sales of equity and debt securities to the public.
Historically, our business has been seasonal and our working capital requirements and capital resources tracked closely to this seasonal pattern. During the first fiscal quarter, accounts receivable reach their lowest level while inventory, accounts payable and short-term borrowings begin to increase. During the second fiscal quarter, receivables, accounts payable and short-term borrowings begin to increase, reflecting the build-up of inventory and related payables in anticipation of the peak lawn and garden selling season. During the third fiscal quarter, inventory levels remain relatively constant while accounts receivable peak and short-term borrowings start to decline as cash collections are received during the peak selling season. During the fourth fiscal quarter, inventory levels are at their lowest, and accounts receivable and payables are substantially reduced through conversion of receivables to cash. As a result of the reduction in sales of garden products manufactured by other parties as a percentage of overall sales, this seasonal pattern has become somewhat less significant.
We service two broad markets: pet supplies and lawn and garden supplies. Our pet supplies businesses sell products that have a year round selling cycle with very little change quarter to quarter. As a result, it is not necessary to carry large quantities of inventory to meet peak demands. Additionally, this level sales cycle eliminates the need for us to give extended credit terms to either our distributor or retailer customers. On the other hand, our lawn and garden businesses are highly seasonal with approximately 63% of Garden Products’ aggregate sales occurring during the second and third fiscal quarters. For many manufacturers of garden products, this seasonality requires them to deliver large quantities of their product well ahead of the peak selling periods. To encourage distributors to carry large amounts of inventory, it has been industry practice for manufacturers to give extended credit terms and/or promotional discounts.
The primary cash flows for the nine months ended June 25, 2005 were $75.4 million in cash used in investing activities partially offset by $42.6 million provided by financing activities and $30.3 million of cash provided by operating activities. Net cash used in investing activities decreased $73.3 million from the prior year due to a $61.5 million decrease in cash used for acquisitions and $15 million paid into an escrow account in the prior fiscal year, which is classified as restricted investments on the condensed consolidated balance sheet, in connection with our appeal in the Scotts litigation. Net cash provided by financing activities decreased $2.7 million as both periods included significant borrowings by the company to finance seasonal working capital needs and to fund acquisitions.
At June 25, 2005, our total debt was $345.4 million versus $289.5 million at June 26, 2004, resulting from borrowings on our credit facility to finance our acquisitions since the third quarter of fiscal 2004.
We currently maintain a $300 million senior secured credit facility consisting of a $125 million revolving credit facility maturing in May 2008 and a $175 million term loan maturing in May 2009. Interest on the term loan is based on a rate equal to LIBOR + 1.75% or the prime rate plus 0.25%, at our option. Interest on the revolving credit facility is based on a rate equal to prime plus a margin, which fluctuates from (0.25)% to 0.75% or LIBOR plus a margin which fluctuates from 1.25% to 2.25%, determined quarterly based on consolidated total debt to consolidated EBITDA for the most recent trailing 12-month period. In February 2005, we exercised an option contained in our credit agreement to borrow an additional $75 million under our six year term loan. The total outstanding borrowings after the draw down under the term loan was approximately $173.5 million. The term loan is payable in quarterly installments of $437,500 with the balance payable in May 2009. This facility is secured by essentially all of our assets, contains certain financial covenants requiring maintenance of minimum levels of interest coverage and maximum levels of senior debt to EBITDA and total debt to EBITDA, and restricts our ability to make treasury stock purchases and pay dividends. We were in compliance with all financial covenants as of June 25, 2005. This facility also requires the lenders’ prior written consent to any material investments in or acquisitions of a business. The balance outstanding at June 25, 2005 under the $125 million revolving credit facility was $20.0 million, and the remaining available borrowing capacity was $96.6 million, with $8.4 million outstanding under certain letters of credit.
In October 2003, we entered into a $75 million pay-floating interest rate swap effectively converting half of our $150 million fixed rate 9-1/8 % senior subordinated notes to a floating rate of LIBOR + 4.04%.
In November 2003, we deposited approximately $15 million into an escrow account in connection with an appeal in the Scotts litigation. The use of this cash is restricted from general corporate purposes and is reflected as a “Restricted Investment” on our balance sheet. See Note 6 – “Contingencies” to our unaudited condensed consolidated financial statements. In July 2005, we reached agreement with Scotts on the amount due and all litigation with Scotts has now been resolved. The award amount has been paid to Scotts from the escrow proceeds which are reported as restricted investments in the accompanying balance sheets as of September 25, 2004 and June 25, 2005. The award amount had been previously accrued for.
19
We believe that cash flows from operating activities, funds available under our credit facility, and arrangements with suppliers will be adequate to fund our presently anticipated working capital requirements for the foreseeable future. We anticipate that our capital expenditures will not exceed $20 million for the next 12 months.
As part of our growth strategy, we have engaged in acquisition discussions with a number of companies in the past, and we anticipate that we will continue to evaluate potential acquisition candidates. If one or more potential acquisition opportunities, including those that would be material, become available in the near future, we may require additional external capital. In addition, such acquisitions would subject us to the general risks associated with acquiring companies, particularly if the acquisitions are relatively large.
Off-Balance Sheet Arrangements
There have been no material changes to the information provided in our Annual Report on Form 10-K for the fiscal year ended September 25, 2004 regarding off-balance sheet arrangements.
Contractual Obligations
There have been no material changes outside the ordinary course of business in our contractual obligations set forth in the Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources in our Annual Report on Form 10-K for the fiscal year ended September 25, 2004.
Weather and Seasonality
Historically, our sales of lawn and garden products have been influenced by weather and climate conditions in the markets we serve. Additionally, Garden Products’ business has been highly seasonal. In fiscal 2004, 63% of Garden Products’ net sales and 58% of our total net sales occurred in the Company’s second and third fiscal quarters. Substantially all of Garden Products’ operating income is typically generated in this period, which has historically offset the operating loss incurred during the first fiscal quarter of the year.
We believe there has been no material change in our exposure to market risk from that discussed in our fiscal 2004 Annual Report filed on Form 10-K.
(a) Our Chief Executive Officer and Chief Financial Officer have reviewed, as of the end of the period covered by this report, the “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) that ensure that information relating to the Company required to be disclosed by us in the reports that we file or submit under the Exchange Act, is recorded, processed, summarized and reported in a timely and proper manner. Based upon this review, we believe that the controls and procedures in place are effective to ensure that information relating to the Company that is required to be disclosed by us in the reports that we file or submit under the Exchange Act is properly disclosed as required by the Exchange Act and related regulations.
(b) Changes in internal controls. There were no significant changes in our internal controls during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
For information on our material legal proceedings, you should read Note 6 “Contingencies” to the unaudited condensed consolidated financial statements in Part I – Item 1 of this report.
Not applicable.
20
Not applicable
21
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.
22