(Mark One)/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended April 2, 2005
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______
Commission File Number 0-24620
DARLING INTERNATIONAL INC.(Exact name of registrant as specified in its charter)
Registrant's telephone number, including area code:(972) 717-0300
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 Rule 12b-2 of the Exchange Act). Yes /X/ No / /
There were 63,914,336 shares of common stock, $0.01 par value, outstanding at May 4, 2005.
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DARLING INTERNATIONAL INC. AND SUBSIDIARIESFORM 10-Q FOR THE THREE MONTHS ENDED APRIL 2, 2005
TABLE OF CONTENTS
PART I: FINANCIAL INFORMATION
PART II: OTHER INFORMATION
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DARLING INTERNATIONAL INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETSApril 2, 2005 and January 1, 2005(in thousands, except shares and per share data)
April 2, January 1, 2005 2005 ----------- ---------- (unaudited) ASSETS - ------ Current assets: Cash and cash equivalents ................................... $ 38,617 $ 37,249 Restricted cash ............................................. 2,370 2,379 Accounts receivable ......................................... 23,520 26,675 Inventories ................................................. 7,591 6,000 Prepaid expenses ............................................ 3,252 3,740 Deferred income taxes ....................................... 4,224 4,080 Assets held for sale ........................................ 833 837 Other ....................................................... 6 13 ------- ------- Total current assets .............................. 80,413 80,973 Property, plant and equipment, less accumulated depreciation of $168,238 at April 2, 2005 and $166,353 at January 1, 2005 .. 75,671 75,398 Collection routes and contracts, less accumulated amortization of $30,132 at April 2, 2005 and $29,163 at January 1, 2005 ....... 15,041 16,006 Goodwill, less accumulated amortization of $1,077 at April 2, 2005 and January 1, 2005 ........................................... 4,429 4,429 Deferred loan costs .............................................. 3,375 3,565 Other assets ..................................................... 2,712 2,438 ------- ------- $181,641 $182,809 ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY - ------------------------------------ Current liabilities: Current portion of long-term debt ........................... $ 5,029 $ 5,030 Accounts payable, principally trade ......................... 8,363 8,144 Accrued expenses ............................................ 29,291 28,005 Accrued interest ............................................ 57 192 ------- ------- Total current liabilities ......................... 42,740 41,371 Long-term debt, net .............................................. 47,022 49,528 Other non-current liabilities .................................... 20,332 20,197 Deferred income taxes ............................................ 3,190 4,478 ------- ------- Total liabilities ................................. 113,284 115,574 ------- ------- Stockholders' equity: Common stock, $0.01 par value; 100,000,000 shares authorized; 63,925,336 and 63,918,346 shares issued and outstanding at April 2, 2005 and at January 1, 2005, respectively ....... 639 639 Additional paid-in capital .................................. 77,396 77,393 Treasury stock, at cost; 21,000 shares at April 2, 2005 and January 1, 2005 .......................................... (172) (172) Accumulated other comprehensive loss ........................ (7,134) (7,331) Accumulated deficit ......................................... (2,372) (3,294) ------- ------- Total stockholders' equity ........................ 68,357 67,235 ------- ------- Commitments and contingencies .................................... $181,641 $182,809 ======= ======= The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONSThree Months Ended April 2, 2005 and April 3, 2004(in thousands, except per share data)(unaudited)
April 2, April 3, 2005 2004 ---------- ---------- Net sales $71,353 $77,540 Costs and expenses: Cost of sales and operating expenses 56,109 58,094 Selling, general and administrative expenses 8,700 8,987 Depreciation and amortization 3,771 3,772 ------- ------- Total costs and expenses 68,580 70,853 ------- ------- Operating income 2,773 6,687 ------- ------- Other income/(expense): Interest expense (1,584) (1,760) Other, net 200 1,395 ------- ------- Total other income/(expense) (1,384) (365) ------- ------- Income from continuing operations before income taxes 1,389 6,322 Income taxes 473 2,408 ------- ------- Income from continuing operations 916 3,914 Income from discontinued operations, net of tax 6 21 ------- ------- Net income $ 922 $ 3,935 ======= ======= Basic and diluted income per share: Continuing operations $ 0.01 $ 0.06 Discontinued operations - - ------- ------- Total $ 0.01 $ 0.06 ======= ======= The accompanying notes are an integral part of these consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWSThree months ended April 2, 2005 and April 3, 2004(in thousands)(unaudited)
April 2, April 3, 2005 2004 ----------- ---------- Cash flows from operating activities: Income from continuing operations $ 916 $ 3,914 Adjustments to reconcile income from continuing operations to net cash provided by operating activities: Depreciation and amortization 3,771 3,772 Gain on disposal of property, plant, equipment and other assets (132) (257) Gain on early extinguishment of debt - (1,306) Deferred taxes (1,432) - Changes in operating assets and liabilities: Restricted cash 9 9 Accounts receivable 3,155 1,653 Inventories and prepaid expenses (1,103) (25) Accounts payable and accrued expenses 1,505 226 Accrued interest (135) (283) Other 282 (129) -------- -------- Net cash provided by continuing operating activities 6,836 7,574 Net cash provided by discontinued operations 6 23 -------- -------- Net cash provided by operating activities 6,842 7,597 -------- -------- Cash flows from investing activities: Capital expenditures (3,118) (1,514) Intangible expenditures (4) - Gross proceeds from disposal of property, plant and equipment and other assets 178 349 -------- -------- Net cash used by investing activities (2,944) (1,165) -------- -------- Cash flows from financing activities: Proceeds from debt - 92,302 Payments on debt (2,507) (85,820) Deferred loan costs (7) (112) Contract payments (19) (95) Issuance of common stock 3 80 -------- -------- Net cash provided/(used) by financing activities (2,530) 6,355 -------- -------- Net increase in cash and cash equivalents 1,368 12,787 Cash and cash equivalents at beginning of period 37,249 24,803 -------- -------- Cash and cash equivalents at end of period $ 38,617 $ 37,590 ======== ======== Supplemental disclosure of cash flow information: Cash paid during the period for: Interest $ 1,519 $ 1,761 ======== ======== Income taxes, net of refunds $ 205 $ 1,366 ======== ======== The accompanying notes are an integral part of these consolidated financial statements.
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Notes to Consolidated Financial StatementsApril 2, 2005 (unaudited)
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The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth below under the heading “Forward Looking Statements” and elsewhere in this report, and under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended January 1, 2005, and in the Company’s other public filings with the SEC.
The following discussion should be read in conjunction with the historical consolidated financial statements and notes thereto.
Overview
Darling International Inc. is a leading provider of rendering, recycling and recovery solutions to the nation’s food industry. The Company collects and recycles animal by-products and used cooking oil from food service establishments and provides grease trap cleaning services to many of the same establishments. The Company processes such raw materials at 24 facilities located throughout the United States, into finished products such as protein (primarily meat and bone meal, “MBM”), tallow (primarily bleachable fancy tallow, “BFT”), and yellow grease (“YG”). The Company sells these products nationally and internationally, primarily to producers of oleo-chemicals, soaps, pet foods, and livestock feed, for use as ingredients in their products or for further processing. The Company’s operations are organized into two segments: Rendering and Restaurant Services. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements contained in the Company’s Form 10-K for the fiscal year ended January 1, 2005.
Major challenges faced by the Company during the first quarter of Fiscal 2005 included reduced raw material supplies, lower finished product prices and high relative prices for diesel fuel and natural gas. The anticipated new government regulations pertaining to Bovine Spongiform Encephalopathy (“BSE”), which were not implemented in the first quarter of Fiscal 2005, contributed to an environment of uncertainty regarding the impact of those regulations. Export markets in foreign countries for U.S. produced finished beef products and other cattle by-products continued to be closed throughout the first quarter of 2005.
Operating income decreased by $3.9 million in the first quarter of Fiscal 2005 compared to the first quarter of Fiscal 2004. The challenges faced by the Company indicate there can be no assurance that operating results achieved by the Company in the first quarter of Fiscal 2005 are indicative of future operating performance of the Company.
Summary of Critical Issues Faced by the Company During the First Quarter of 2005
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Summary of Critical Issues and Known Trends Faced by the Company in 2005 and Thereafter
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These challenges indicate there can be no assurance that operating results of the Company achieved in the first quarter of Fiscal 2005 are indicative of future operating performance of the Company.
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Results of Operations
Three Months Ended April 2, 2005 Compared to Three Months Ended April 3, 2004
Summary of Key Factors Impacting First Quarter 2005 Results:
Principal factors which contributed to a $3.9 million (58.5%) decrease in operating income, which are discussed in greater detail in the following section, were:
These decreases were partially offset by:
Summary of Key Indicators of 2005 Performance:
Principal indicators which management routinely monitors and compares to previous periods as an indicator of problems or improvements in operating results include:
These indicators and their importance are discussed below in greater detail.
Prices for finished product commodities that the Company produces are quoted each business day on the Jacobsen index, an established trading exchange price publisher. These finished products are MBM, BFT, and YG. The prices quoted are for delivery of the finished product at a specified location. These prices are relevant because they provide an indication of a component of revenue and achievement of business plan benchmarks on a daily basis. The Company’s actual sales prices for its finished products may vary from the Jacobsen index because the Company’s finished products are delivered to multiple locations in different geographic locations which utilize different price indexes. Average Jacobsen prices (at the specified delivery point) for the first quarter of Fiscal 2005 compared to average Jacobsen prices for the first quarter of Fiscal 2004 follow:
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The decreases in average price of the finished products the Company sells had an unfavorable impact on revenue which was partially offset by a positive impact to the Company’s raw material cost, due to formula pricing arrangements which compute raw material cost, based upon the price of finished product.
Raw material volume represents the quantity (pounds) of raw material collected from suppliers, including beef, pork, poultry, and used cooking oils. Raw material volumes provide an indication of future production of finished products available for sale and are a component of potential future revenue.
Finished product production volumes are the end result of the Company’s production processes, and directly impact goods available for sale, and thus become an important component of sales revenue. Yield on production is a ratio of production volume (pounds) divided by raw material volume (pounds), and provides an indication of effectiveness of the Company’s production process. Factors impacting yield on production include quality of raw material and warm weather during summer months, which rapidly degrades raw material.
The Company charges collection fees which are included in net sales in order to offset a portion of the expense incurred in collecting raw material. Each month the Company monitors both the collection fee charged suppliers, which is included in net sales, and collection expense, which is included in cost of sales. The monitoring of collection fees and collection expense provides an indication of achievement of the Company’s business plan.
Net Sales. The Company collects and processes animal by-products (fat, bones and offal) and used restaurant cooking oil to produce finished products of MBM, BFT and YG. Sales are significantly affected by finished goods prices, quality of raw material and volume of raw material. Net sales include the sales of produced finished goods, collection fees, grease trap services and finished goods purchased for resale.
During the first quarter of Fiscal 2005, net sales decreased by $6.1 million (7.9%) to $71.4 million as compared to $77.5 million during the first quarter of Fiscal 2004. The decrease in net sales was primarily due to the following (in millions of dollars):
Cost of Sales and Operating Expenses. Cost of sales and operating expenses include cost of raw material, the cost of product purchased for resale, and the cost to collect and process the raw material. The Company utilizes both fixed and formula pricing methods for the purchase of raw materials. Fixed prices are adjusted where possible for changes in competition and significant changes in finished goods market conditions, while raw materials purchased under formula prices are correlated with specific finished goods prices.
During the first quarter of Fiscal 2005, cost of sales and operating expenses decreased $2.0 million (3.4%) to $56.1 million as compared to $58.1 million during the first quarter of Fiscal 2004. The decrease in cost of sales and operating expenses was primarily due to the following (in millions of dollars):
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Selling, General and Administrative Expenses. Selling, general and administrative expenses were $8.7 million during the first quarter of Fiscal 2005, a $0.3 million decrease (3.3%) from $9.0 million during the first quarter of Fiscal 2004, primarily due to the following (in millions of dollars):
Depreciation and Amortization. Depreciation and amortization charges were $3.8 million during the first quarter of Fiscal 2005 unchanged from $3.8 million during the first quarter of Fiscal 2004.
Interest Expense. Interest expense was $1.6 million during the first quarter of Fiscal 2005 compared to $1.8 million during the first quarter of Fiscal 2004, a decrease of $0.2 million, primarily due to the following (in millions of dollars):
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Other Income/Expense. Other income was $0.2 million in the first quarter of Fiscal 2005, a decrease of $1.2 million as compared to other income of $1.4 million in the first quarter of Fiscal 2004. The decrease in other income in the first quarter of Fiscal 2005 is primarily due to the following (in millions of dollars):
Interest income increased by $0.2 million in the first quarter of 2005 as a result of the investment of the cash on the balance sheet and other income included a gain on the sale of equipment of $0.1 million.
Included in Other Income in Fiscal 2004 was a gain on extinguishment of debt of $1.3 million, which resulted from retirement of debt with a carrying value of $20.1 million with a cash payment of $18.0 million, due to SFAS 15 accounting, net of related deferred loan costs of $0.8 million also extinguished upon payment of the debt. Also included in other income in the first quarter of Fiscal 2004 was a gain on the sale of property and equipment of approximately $0.3 million, which included the sale of the Company’s land in Oklahoma City, OK, which was sold for a sales price of approximately $0.3 million and had a net book value at the time of sale of less than $0.1 million.
Income Taxes. The Company recorded income tax expense of $0.5 million for the first quarter of Fiscal 2005, compared to income tax expense of $2.4 million recorded in the first quarter of Fiscal 2004, a decrease of $1.9 million (79.2%), primarily due to the decreased pre-tax earnings of the Company in Fiscal 2005.
Discontinued Operations. The Company recorded a profit from discontinued operations, net of applicable taxes, related to closure and sale of certain assets of the Company’s London, Ontario, Canadian subsidiary in the first quarter of Fiscal 2005, compared to income from discontinued operations in the first quarter of Fiscal 2004.
FINANCING, LIQUIDITY AND CAPITAL RESOURCES
On April 2, 2004, the Company entered into a new Senior Credit Agreement with new lenders, and entered into a new lender acknowledgement on May 28, 2004, that increased the committed amount as permitted by the Senior Credit Agreement. This refinancing replaces the prior Amended and Restated Credit Agreement executed on May 13, 2002, which is summarized below. The principal components of the refinancing consist of the following.
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On December 31, 2003, the Company issued Senior Subordinated Notes in the amount of $35.0 million and applied the net proceeds to the reduction of the outstanding term loan of its then outstanding prior Amended and Restated Credit Agreement executed on May 13, 2002. The Senior Subordinated Notes have a term of six years, maturing on December 31, 2009. Beginning June 1, 2006, the Company may prepay the outstanding principal amount of the Senior Subordinated Notes in whole or in part, plus accrued and unpaid interest, plus a prepayment fee of 5.5%, which declines each year after this date. Interest accrues on the outstanding principal balance of the Senior Subordinated Notes at an annual rate of 12%, payable quarterly in arrears. Restrictive covenants in the Senior Subordinated Notes permit the Company, within limitations defined in the Senior Subordinated Notes, to incur additional indebtedness and to pay cash dividends.
The Company’s new Senior Credit Agreement and Senior Subordinated Notes consist of the following elements at April 2, 2005 (in thousands):
Substantially all of the Company’s assets are either pledged or mortgaged as collateral for borrowings under the new Senior Credit Agreement. The new Senior Credit Agreement contains certain terms and covenants, which permit the incurrence of additional indebtedness, the payment of cash dividends, the retention of certain proceeds from sales of assets, and capital expenditures, within limitations defined by the new Senior Credit Agreement, and requires the maintenance of certain minimum financial ratios, including: minimum fixed charge coverage ratio; maximum leverage ratio, and minimum tangible net worth ratio, each as defined in the new Senior Credit Agreement. The Company is currently in compliance with all of the covenants contained in the new Senior Credit Agreement.
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The classification of long-term debt in the accompanying April 2, 2005 consolidated balance sheet is based on the contractual repayment terms of the debt issued under the Senior Subordinated Notes and the new Senior Credit Agreement.
On April 2, 2005, the Company had working capital of $37.7 million and its working capital ratio was 1.88 to 1 compared to working capital of $39.6 million and a working capital ratio of 1.96 to 1 on January 1, 2005. At April 2, 2005, the Company had unrestricted cash of $38.6 million and funds available under the revolving credit facility of $37.9 million, compared to unrestricted cash of $37.2 million and funds available under the revolving credit facility of $36.3 million at January 1, 2005.
Net cash provided by continuing operating activities was $6.8 million and $7.6 million for the first quarter ended April 2, 2005 and April 3, 2004, respectively, a decrease of $0.8 million, primarily due to lower income from continuing operations, an increase in inventory partially offset by an increase in accounts payable and accrued expenses and proceeds from accounts receivable. Cash used by investing activities was $2.9 million for the first three months of Fiscal 2005, compared to $1.2 million for the first three months of Fiscal 2004, an increase of $1.7 million, primarily due to higher capital investment in the first quarter of Fiscal 2005. Net cash used by financing activities was $2.5 million for the three months ended April 2, 2005, compared to cash provided of $6.4 million for the three months ended April 3, 2004, an increase of cash used of $8.9 million, principally due to proceeds from the Company’s new Senior Credit Agreement, consummated on April 2, 2004.
The Company made capital expenditures of $3.1 million during the first three months of Fiscal 2005, compared to capital expenditures of $1.5 million in the first three months of Fiscal 2004, for a net increase of $1.6 million primarily due to timing of planned capital investment between the two years. Capital expenditures related to compliance with environmental regulations were $0.4 million and $0.1 million for the three months ended April 2, 2005 and April 3, 2004, respectively.
Based upon the underlying terms of the new Senior Credit Agreement, approximately $5.0 million in current debt, which is included in current liabilities on the Company’s balance sheet at April 2, 2005, will be due during the next twelve months, consisting of scheduled installment payments of $1.25 million due each quarter.
Based upon the annual actuarial estimate, current accruals, and claims paid during the first three months of Fiscal 2005, the Company has accrued approximately $5.4 million it expects will become due during the next twelve months in order to meet obligations related to the Company’s self insurance reserves and accrued insurance which are included in current accrued expenses at April 2, 2005. The self insurance reserve is composed of estimated liability for claims arising for workers’ compensation, and for auto liability and general liability claims. The self insurance reserve liability is determined annually, based upon a third party actuarial estimate. The actuarial estimate may vary from year to year, due to changes in cost of health care, the pending number of claims, or other factors beyond the control of management of the Company. No assurance can be given that the Company’s funding obligations under its self insurance reserve will not increase in the future.
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Based upon current actuarial estimates, the Company expects to pay approximately $3.1 million in order to meet minimum pension funding requirements during the next twelve months, which will reduce current accrued compensation and benefit expenses. The minimum pension funding requirements are determined annually, based upon a third party actuarial estimate. The actuarial estimate may vary from year to year, due to fluctuations in return on investments or other factors beyond the control of management of the Company or the administrator of the Company’s pension funds. No assurance can be given that the minimum pension funding requirements will not increase in the future.
The Company’s management believes that cash flows from operating activities at the current level in Fiscal 2005, unrestricted cash, and funds available under the new Senior Credit Agreement should be sufficient to meet the Company’s working capital needs and capital expenditures for at least the next twelve months. The impact on cash flows from operations in Fiscal 2005 of the occurrence of BSE in the United States or elsewhere, lower raw material volumes available to the Company due to weak margins in the meat processing industry, regulations by government agencies, the impact on export markets, and the impact on market prices for the Company’s finished products is not known at this time. These factors, coupled with high prices for natural gas and diesel fuel, among others, could either positively or negatively impact the Company’s results of operations in 2005 and thereafter. The Company cannot provide assurance that the cash flows from operating activities generated in the first quarter of Fiscal 2005 are indicative of the future cash flows from operating activities which will be generated by the Company’s operations. The Company reviews the appropriate use of unrestricted cash periodically. Although no decision has been made as to non-ordinary course cash usages at this time, potential usages could include opportunistic capital expenditures or investments in response to governmental regulations relating to BSE, and/or acquisitions, as well as suitable cash conservation to withstand adverse commodity cycles.
The current economic environment in the Company’s markets has the potential to adversely impact its liquidity in a variety of ways, including through reduced sales, potential inventory buildup, or higher operating costs.
The principal products that the Company sells are commodities, the prices of which are quoted on established commodity markets and are subject to volatile changes. Although the current market prices of these commodities are stable, a further decline in these prices has the potential to adversely impact the Company’s liquidity. A disruption in international sales, a decline in commodities prices, or a rise in energy prices resulting from the recent war with Iraq and the subsequent political instability and uncertainty, has the potential to adversely impact the Company’s liquidity. There can be no assurance that a decline in commodities prices, a rise in energy prices, a slowdown in the U.S. or international economy, or other factors, including political instability in the Middle East or elsewhere, and the macroeconomic effects of those events, will not cause the Company to fail to meet management’s expectations, or otherwise result in liquidity concerns.
OFF BALANCE SHEET OBLIGATIONS
Based upon the underlying purchase agreements, the Company has commitments to purchase $3.2 million of finished products and natural gas during the next twelve months, which are not included in liabilities on the Company’s balance sheet at April 2, 2005. These purchase agreements are entered into in the normal course of the Company’s business and are not subject to derivative accounting. The commitments will be recorded on the balance sheet of the Company when delivery of these commodities occurs and ownership passes to the Company during Fiscal 2005, in accordance with accounting principles generally accepted in the United States.
Based upon the underlying lease agreements, the Company expects to pay approximately $6.7 million in operating lease obligations during the next twelve months which are not included in liabilities on the Company’s balance sheet at April 2, 2005. These lease obligations are included in cost of sales or selling, general, and administrative expense as the underlying lease obligation comes due, in accordance with accounting principles generally accepted in the United States.
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CRITICAL ACCOUNTING POLICIES
The Company follows certain significant accounting policies when preparing its consolidated financial statements. A complete summary of these policies is included in Note 1 to the Consolidated Financial Statements included in this report.
Certain of the policies require management to make significant and subjective estimates or assumptions which may deviate from actual results. In particular, management makes estimates regarding estimates of bad debt expense, valuation of inventories, estimates of useful life of long-lived assets related to depreciation and amortization expense, estimates regarding fair value of the Company’s reporting units and future cash flows with respect to assessing potential impairment of both long-lived assets and goodwill, estimates of liability with respect to medical insurance liability, self-insurance, environmental, and litigation reserves, pension liability, estimates of income tax expense, and estimates of pro-forma expense related to stock options granted. Each of these estimates is discussed in greater detail in the following discussion.
Accounts Receivable and Allowance for Doubtful Accounts
In accordance with SFAS No. 5, Accounting for Contingencies, the Company maintains allowances for doubtful accounts for estimated losses resulting from customers’ non-payment of trade accounts receivable owed to the Company. These trade receivables arise in the ordinary course of business from sales of raw material, finished product or services to the Company’s customers. The estimate of allowance for doubtful accounts is based upon the Company’s bad debt experience, prevailing market conditions, aging of trade accounts receivable, and interest rates, among other factors. If the financial condition of the Company’s customers deteriorates, resulting in the customer’s inability to pay the Company’s receivable as it comes due, additional allowance for doubtful accounts may be required. Accounts receivable was approximately $23.5 million and $26.7 million, and the allowance for doubtful accounts was approximately $0.5 million and $0.8 million, at April 2, 2005 and January 1, 2005, respectively.
Inventories
The Company’s inventories are valued at the lower of cost or market. Finished product manufacturing cost is calculated using the first-in, first-out (FIFO) method, based upon the Company’s raw material costs, collection and factory production operating expenses, and depreciation expense on collection and factory assets. Market values of inventory are estimated at each plant location, based upon either the backlog of unfilled sales orders at the balance sheet date, or for unsold inventory, upon regional finished product prices quoted in the Jacobsen index at the balance sheet date. Estimates of market value, based upon the backlog of unfilled sales orders or upon the Jacobsen index, assume that the inventory held by the Company at the balance sheet date will be sold at the estimated market finished product sales price, subsequent to the balance sheet date. Actual sales prices received on future sales of inventory held at the end of a period may vary from either the backlog unfilled sales order price or the Jacobsen index quotation at the balance sheet date. Such variances could cause actual sales prices realized on future sales of inventory to be different than the estimate of market value of inventory at the end of the period. Inventories were approximately $7.6 million and $6.0 million at April 2, 2005 and January 1, 2005, respectively.
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Long-Lived Assets Depreciation and Amortization Expense and Valuation
The Company’s property, plant and equipment are recorded at cost when acquired. Depreciation expense is computed on property, plant and equipment based upon a straight line method over the estimated useful life of the assets, which is based upon a standard classification of the asset group. Buildings and improvements are depreciated over a useful life of 15 to 30 years, machinery and equipment are depreciated over a useful life of 3 to 10 years, and vehicles are depreciated over a life of 2 to 6 years. These useful life estimates have been developed based upon the Company’s historical experience of asset life utility, and whether the asset is new or used when placed in service. The actual life and utility of the asset may vary from this estimated life. Useful lives of the assets may be modified from time to time when the future utility or life of the asset is deemed to change from that originally estimated when the asset was placed in service. Depreciation expense was approximately $2.8 million and $2.8 million, at April 2, 2005 and April 3, 2004, respectively.
The Company’s intangible assets, including routes, raw material supply agreements and non-compete agreements are recorded at fair value when acquired. Amortization expense is computed on these intangible assets based upon a straight line method over the estimated useful life of the assets, which is based upon a standard classification of the asset group. Collection routes are amortized over a useful life of 8 to 15 years; raw material supply agreements and non-compete agreements are amortized over a useful life of 3 to 10 years. The actual economic life and utility of the asset may vary from this estimated life. Useful lives of the assets may be modified from time to time when the future utility or life of the asset is deemed to change from that originally estimated when the asset was placed in service. Amortization expense was approximately $1.0 million and $1.0 million at April 2, 2005 and April 3, 2004, respectively.
The Company reviews the carrying value of long lived assets on a regular basis, including at the end of each fiscal year, for indications of impairment. Impairment is indicated whenever the carrying value of the asset is not recoverable or exceeds estimated fair value. For purposes of calculating impairment on long lived operating assets, the Company has defined its reporting units to be each of the Company’s plant locations. The Company estimates fair value of its long lived assets at each plant based upon future undiscounted net cash flows from use of those assets. In calculating such estimates, actual historical operating results and anticipated future economic factors, such as future business volume, future finished product prices, and future operating costs and expense are evaluated and estimated as a component of the calculation of future undiscounted cash flows for each operating plant location. The estimates of fair value of the reporting units and of future undiscounted net cash flows from operation of these assets could change if actual volumes, prices, costs or expenses vary from these estimates. A future reduction of earnings in the Company’s plants could result in an impairment charge because the estimate of fair value would be negatively impacted by a reduction of earnings.
The Company reviews the carrying value of assets held for sale on a regular basis for indications of impairment. Impairment is indicated whenever the carrying value of the asset exceeds estimated fair value. For purposes of calculating impairment on assets held for sale, the Company utilizes estimated sales value of the assets as an estimate of fair value. The estimates of fair value of the assets held for sale could change if the actual sales value realized, or realizable, varies from the estimated sale value.
The net book value of property, plant and equipment was approximately $75.7 million and $75.4 million at April 2, 2005 and January 1, 2005, respectively. The net book value of intangible assets, including deferred loan cost, was approximately $18.4 million and $19.6 million at April 2, 2005 and January 1, 2005, respectively.
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Goodwill Valuation
The Company reviews the carrying value of goodwill on a regular basis, including at the end of each fiscal year, for indications of impairment at each plant location which has recorded goodwill as an asset. Impairment is indicated whenever the carrying value of plant assets exceeds the estimated fair value of plant assets. For purposes of evaluating impairment of goodwill, the Company estimates fair value of plant assets at each plant, based upon future discounted net cash flows from use of those assets. In calculating such estimates, actual historical operating results and anticipated future economic factors, such as future business volume, future finished product prices, and future operating costs and expenses are evaluated and estimated as a component of the calculation of future discounted cash flows for each operating plant location with recorded goodwill. The estimates of fair value of assets at these plant locations and of future discounted net cash flows from operation of these assets could change if actual volumes, prices, costs or expenses vary from these estimates. A future reduction of earnings in the plants with recorded goodwill could result in an impairment charge because the estimate of fair value would be negatively impacted by a reduction of earnings at those plants. Goodwill was approximately $4.4 million at both April 2, 2005 and January 1, 2005.
Accrued Medical Claims Liability
The Company provides a self-insured group health plan to its employees, which provides medical benefits to participating employees. The Company has an employer’s stop loss insurance policy to cover individual claims in excess of $175,000 per employee per year. The amount charged to medical insurance expense includes claims paid during the year and includes estimates of liabilities for outstanding medical claims under the plan at the balance sheet date, based upon historical claims expense and historical claims submission information, and also includes an accrual for estimated severe illness claims, which is based upon the stop loss limit per employee and the number of employees filing those claims. If actual future medical claims by employees varies significantly from historical spending or if the actual timeliness of submission of those claims by medical care providers changes, the actual medical claims may vary from the estimated liability. The actual cost of providing medical care to severely ill employees and dependents may vary from estimates if the patient either recovers or dies. Accrued medical claims liability included in accrued expenses was approximately $2.4 million and $2.3 million at April 2, 2005 and January 1, 2005, respectively.
Self Insurance, Environmental, and Legal Reserves
The Company purchases its workers compensation, auto and general liability insurance on a retrospective basis. The Company estimates and accrues its expected ultimate costs related to claims occurring during each fiscal year and carries this accrual as a reserve until such claims are paid by the Company. Estimates of self insurance liability are based upon the report of a third party actuarial report, which the Company relies upon in calculating its estimates. The Company has also accrued loss reserves related to environmental and litigation matters, based upon estimated undiscounted future costs. In developing estimates of loss, the Company utilizes its staff, outside consultants, and outside counsel as sources of information and judgment as to the expected undiscounted future costs of the claims. With respect to the Company’s self insurance, environmental and litigation reserves, estimates of reserve liability could change if future events are different than those included in the estimates of the actuary, consultants or management of the Company. The reserve for insurance, environmental, and litigation contingencies included in accrued expenses and other non-current liabilities were approximately $15.5 million and $13.9 million at April 2, 2005 and January 1, 2005, respectively.
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Pension Liability
The Company provides retirement benefits to employees under separate final-pay noncontributory pension plans for salaried and hourly employees (excluding those employees covered by a union-sponsored plan), who meet service and age requirements. Benefits are based principally on length of service and earnings patterns during the five years preceding retirement. Pension expense and pension liability recorded by the Company is based upon an annual actuarial estimate provided by a third party administrator. Factors included in estimates of current year pension expense and pension liability at the balance sheet date include estimated future service period of employees, estimated future pay of employees, estimated future retirement ages of employees, and the projected time period of pension benefit payments. Two of the most significant assumptions used to calculate future pension obligations are the discount rate applied to pension liability and the expected rate of return on pension plan assets. These assumptions and estimates are subject to the risk of change over time, and each factor has inherent uncertainties which neither the actuary nor the Company is able to control, or to predict with certainty.
The discount rate applied to the Company’s pension liability is the interest rate used to calculate the present value of the pension benefit obligation. The discount rate is based on the yield of long-term corporate fixed income securities at the measurement date of October 1 in the year of calculation. The weighted average discount rate was 6.0% and 6.5% at October 1 in Fiscal 2004 and Fiscal 2003, respectively.
The expected rate of return on the Company’s pension plan assets is the interest rate used to calculate future returns on investment of the plan assets. The expected return on plan assets is a long-term assumption whose accuracy can only be assessed over a long period of time. The weighted average expected return on pension plan assets was 8.75% for both Fiscal 2004 and Fiscal 2003.
The Company has recorded a minimum pension liability of approximately $13.6 million and $9.0 million at January 1, 2005 and January 3, 2004, respectively. The Company’s net pension cost was approximately $0.8 million, and $0.7 million at April 2, 2005 and April 3, 2004, respectively.
Income Taxes
In calculating net income, the Company includes estimates in the calculation of tax expense, the resulting tax liability, and in future utilization of deferred tax assets which arise from temporary timing differences between financial statement presentation and tax recognition of revenue and expense. The Company’s deferred tax assets include net operating loss carry-forward which is limited to approximately $0.7 million per year in future utilization due to the change in majority control, resulting from the May 2002 recapitalization of the Company. As a result of these matters, the estimate of future utilization of deferred tax assets relies upon the forecast of future reversal of the Company’s deferred tax liabilities, which provide some evidence of the ability of the Company to utilize deferred tax assets in future years. Valuation allowances for deferred tax assets are recorded when it is more likely than not that deferred tax assets will expire before they are utilized and the tax benefit is realized. Based upon the Company’s evaluation of these matters, a significant portion of the Company’s net operating loss carry-forwards will expire unused. The valuation allowance established to provide a reserve against these deferred tax assets was approximately $20.3 million and $20.3 million at April 2, 2005 and January 1, 2005, respectively.
Stock Option Expense
The Company currently discloses the pro forma effects on net income of expense of stock options issued, and the Company will begin recording compensation expense related to stock options granted, beginning in the first quarter of Fiscal 2006, in accordance with implementation requirements for recently issued SFAS 123 R. The calculation of expense of stock options issued utilizes the Black-Scholes mathematical model which estimates the fair value of the option award to the holder and the compensation expense to the Company, based upon estimates of volatility, risk-free rates of return at the date of issue, and projected vesting of the option grants. If actual share price volatility or vesting differs from the projection, the actual expense recorded may vary. The Company’s pro forma expense related to stock options granted was approximately $0.1 million and $0.1 million at April 2, 2005 and April 3, 2004, respectively.
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NEW ACCOUNTING PRONOUNCEMENTS
No new accounting pronouncements were issued which were applicable to the Company during the first quarter of Fiscal 2005.
FORWARD LOOKING STATEMENTS
This Quarterly Report on Form 10-Q includes “forward-looking” statements that involve risks and uncertainties. The words “believe,” “anticipate,” “expect,” “estimate,” “intend,” and similar expressions identify forward-looking statements. All statements other than statements of historical facts included in the Quarterly Report on Form 10-Q, including, without limitation, the statements under the section entitled “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Legal Proceedings” and located elsewhere herein regarding industry prospects and the Company’s financial position are forward-looking statements. Actual results could differ materially from those discussed in the forward-looking statements as a result of certain factors. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, it can give no assurance that such expectations will prove to be correct.
In addition to those factors discussed in this report and under the heading “Risk Factors” in Item 7A of Part I of the Company’s annual report on Form 10-K for the year ended January 1, 2005, and in the Company’s other public filings with the SEC, important factors that could cause actual results to differ materially from the Company’s expectations include: the Company’s continued ability to obtain sources of supply for its rendering operations; general economic conditions in the American, European and Asian markets; prices in the competing commodity markets which are volatile and are beyond the Company’s control; and BSE and its impact on finished product prices, export markets, energy prices and government regulation are still evolving and are beyond the Company’s control. Among other things, future profitability may be affected by the Company’s ability to grow its business which faces competition from companies which may have substantially greater resources than the Company.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Market risks affecting the Company are exposures to changes in interest rates on debt and the price of natural gas used in the Company’s plants. The Company has used interest rate and natural gas swaps to manage these related risks. The Company is not currently party to any interest rate swap agreements. The Company uses natural gas forward purchase agreements with its suppliers to manage the price risk of natural gas used in its facilities.
As of April 2, 2005, the Company had forward purchase agreements in place for purchases of approximately $0.5 million of natural gas.
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ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures. As required by Exchange Act Rule 13a-15(b), the Company’s management, including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation as of the end of the period covered by this report of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. As defined in Exchange Act Rule 13a-15(e) and 15d-15(e) under the Exchange Act, disclosure controls and procedures are controls and other procedures of the Company that are designed to ensure information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to Company management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.
Changes in Internal Control Over Financial Reporting. As required by Exchange Act Rule 13a-15(d), the Company’s management, including the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of the Company’s internal control over financial reporting to determine whether any change occurred during the quarter covered by this report that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. Based on that evaluation, there have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date of their evaluation in connection with the preparation of this quarterly report on Form 10-Q.
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FORM 10-Q FOR THE THREE MONTHS ENDED APRIL 2, 2005 PART II: Other Information
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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