SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
For Quarterly Period Ended October 3, 2004
Commission File Number 0-12016
INTERFACE, INC.
2859 PACES FERRY ROAD, SUITE 2000, ATLANTA, GEORGIA 30339
(770) 437-6800
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 o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o
Shares outstanding of each of the registrant’s classes of common stock at November 9, 2004:
INTERFACE, INC.INDEX
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PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTERFACE, INC. AND SUBSIDIARIES
See accompanying notes to consolidated condensed financial statements.
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(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
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(IN THOUSANDS)
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NOTE 1 — CONDENSED FOOTNOTES
As contemplated by the Securities and Exchange Commission (the “Commission”) instructions to Form 10-Q, the following footnotes have been condensed and, therefore, do not contain all disclosures required in connection with annual financial statements. Reference should be made to the Company’s year-end financial statements and notes thereto contained in its Annual Report on Form 10-K for the fiscal year ended December 28, 2003, as filed with the Commission.
The financial information included in this report has been prepared by the Company, without audit. In the opinion of management, the financial information included in this report contains all adjustments (all of which are normal and recurring) necessary for a fair presentation of the results for the interim periods. Nevertheless, the results shown for interim periods are not necessarily indicative of results to be expected for the full year. The December 28, 2003, consolidated balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States.
In September 2003, the Company sold substantially all of the assets of its raised/access flooring business. In addition, the Company has committed to a plan to exit its owned Re:Source dealer businesses, which are part of a broader network of owned and aligned dealers that sell and install floorcovering products, and in the third quarter 2004 the Company began to dispose of several of its dealer subsidiaries. The balances of all of these businesses, as well as the businesses of a small dealer business in Australia and a small residential fabrics business that the Company has also decided to exit, have been segregated and reported as discontinued operations for all periods presented.
Additionally, certain reclassifications have been made, including certain reclassifications from short-term liabilities to long-term liabilities and certain reclassifications related to discontinued operations, as of December 28, 2003, to conform to the current period presentation.
NOTE 2 — INVENTORIES
Inventories are summarized as follows:
NOTE 3 — RESTRUCTURING CHARGES
2002 Restructuring
During the fourth quarter of 2002, the Company recorded a pre-tax restructuring charge of $23.4 million. The charge reflected: (i) the consolidation of three fabrics manufacturing facilities; (ii) the further rationalization of the Re:Source Americas operations; (iii) a worldwide workforce reduction of approximately 206 employees; and (iv) the consolidation of certain European facilities. In 2003, we recognized an additional pre-tax restructuring charge related to this plan of $6.2 million ($4.6 million of which was recorded in the first nine months of 2003), primarily related to the incurrence of facilities consolidation costs and further staff reductions.
Specific elements of the restructuring activities, the related costs and current status of the plan are discussed below.
United States
Sluggish economic conditions in 2002 caused a decline in demand for fabrics, floorcovering and related services. In order to better match our cost structure to the expected revenue base, the Company consolidated three fabrics manufacturing plants, closed vacated facilities and made other head-count reductions. In the fourth quarter of 2002, a charge of approximately $13.2 million was recorded representing the relocation of equipment, the reduction of carrying value of certain property and equipment, product rationalization and other costs to consolidate these operations. Additionally, in the fourth quarter of 2002, the Company recorded approximately $1.7 million of termination benefits associated with the facility closures and other head-count reductions.
Europe/Australia
The soft global economy during 2002 led management to conclude that further right-sizing of the Europe and Australia operations was necessary. As a result, the Company elected to consolidate certain production and administrative facilities throughout Europe and
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Australia. A charge of approximately $4.6 million was recorded in the fourth quarter of 2002 representing the reduction of carrying value of the related property and equipment and other costs to consolidate these operations. Additionally, the Company recorded approximately $4.0 million of termination benefits associated with the facility closures.
A summary of the restructuring activities from the initiation of the plan through December 28, 2003, is presented below:
The restructuring charge was comprised of $16.0 million of cash expenditures for severance benefits and other costs, and $13.6 million of non-cash charges, primarily for the write-down of carrying value and disposal of certain assets. No additional restructuring charges have been incurred during 2004.
The termination benefits of $7.3 million, primarily related to severance costs, are a result of aggregate reductions of 271 employees through October 3, 2004. The staff reductions as originally planned were expected to be as follows:
The following tables display the cash activities, during the nine-month period ending October 3, 2004, related to the 2002 restructuring summarized above:
Termination Benefits
Other Costs To Exit Activities
NOTE 4 – INCOME (LOSS) PER SHARE
Basic income (or loss) per share is computed by dividing net income (or loss) to common shareholders by the weighted average number of shares of Class A and Class B Common Stock outstanding during the period. Shares issued or reacquired during the period have been weighted for the portion of the period that they were outstanding. Basic income (or loss) per share has been computed based upon 50,558,000 shares and 50,273,000 shares outstanding for the three-month periods ended October 3, 2004, and September 28, 2003, respectively, and based upon 50,537,000 shares and 50,247,000 shares outstanding for the nine-month periods ended October 3, 2004, and September 28, 2003, respectively. Diluted income (or loss) per share is calculated in a manner consistent with that of basic income (or loss) per share while giving effect to all potentially dilutive common shares that were outstanding during the period. Diluted income (or loss) per share has been computed based upon 52,099,000 shares and 50,970,000 shares outstanding for the three-month periods ended
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October 3, 2004, and September 28, 2003, respectively, and based upon 52,038,000 shares and 50,529,000 shares outstanding for the nine-month periods ended October 3, 2004 and September 28, 2003, respectively. During the three-month and nine-month periods ended October 3, 2004, there were vested, unexercised, in the money stock options for 2,072,000 shares and 2,072,000 shares, respectively. During the three-month and nine-month periods ended September 28, 2003, there were vested, unexercised, in the money stock options for 1,038,000 shares and 275,000 shares, respectively.
NOTE 5 — SEGMENT INFORMATION
Effective December 28, 2003, the Company changed its method of classifying its business into segments. All prior periods have been restated to reflect this change. In the second quarter of 2004, we changed the segment name “Services” to “Re:Source Network”, and we changed the segment name “Broadloom” to “Bentley Prince Street”, to better reflect the nature of the businesses that comprise these segments. (The former segment known as the Re:Source Network, which primarily encompassed our owned Re:Source dealers that provide carpet installation and maintenance services in the United States, is now reported as discontinued operations as required by GAAP.)
Based on the quantitative thresholds specified in SFAS No. 131, the Company has determined that it now has four reportable segments: (1) the Modular Carpet segment, which includes our Interface, Heuga and InterfaceFLOR modular carpet businesses, (2) the Bentley Prince Street segment, which includes our Bentley and Prince Street broadloom, modular carpet and area rug businesses, (3) the Fabrics Group segment, which includes all of our fabrics businesses worldwide, and (4) the Specialty Products segment, which includes Pandel, Inc., a producer of vinyl carpet tile backing and specialty mat and foam products, and also includes our Intersept antimicrobial sales and licensing program.
The accounting policies of the operating segments are the same as those described in the Summary of Significant Accounting Policies contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 28, 2003, as filed with the Commission. Segment amounts disclosed are prior to any elimination entries made in consolidation, except in the case of Net Sales, where intercompany sales have been eliminated. The chief operating decision maker evaluates performance of the segments based on operating income. Costs excluded from this profit measure primarily consist of allocated corporate expenses, interest/other expense and income taxes. Corporate expenses are primarily comprised of corporate overhead expenses. Assets not identifiable to any individual segment are corporate assets, which are primarily comprised of cash and cash equivalents, short-term investments, intangible assets and intercompany amounts, which are eliminated in consolidation.
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Segment Disclosures
Summary information by segment follows:
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A reconciliation of the Company’s total segment operating income, depreciation and amortization, and assets to the corresponding consolidated amounts follows:
NOTE 6 — LONG-TERM DEBT
On June 18, 2003, we amended and restated our senior revolving credit facility. Under the revolving credit facility, as under its predecessor, the maximum aggregate amount of loans and letters of credit available to us at any one time is $100 million, subject to a borrowing base limitation. The revolving credit facility matures on October 1, 2007. The revolving credit facility includes a domestic U.S. Dollar syndicated loan and letter of credit facility up to the lesser of (1) $100 million, or (2) a borrowing base equal to the sum of specified percentages of eligible accounts receivable, finished goods inventory and raw materials inventory in the U.S. (the percentages and eligibility requirements for the domestic borrowing base are specified in the credit facility), less certain reserves. Any advances to Interface, Inc. or Interface Europe B.V. under the domestic loan facility will reduce borrowing availability under the entire revolving credit facility. The revolving credit facility also includes a multicurrency syndicated loan and letter of credit facility in British Pounds and Euros of up to the lesser of (1) the equivalent of U.S. $15 million, or (2) a borrowing base equal to the sum of specified percentages of eligible accounts receivable and finished goods inventory of Interface Europe, Ltd. and certain of its subsidiaries (the percentages and eligibility requirements for the multicurrency borrowing base are specified in the credit facility). Any advances under the multicurrency loan facility will reduce borrowing availability under the domestic loan facility.
Interest on borrowings and letters of credit under the revolving credit facility is charged at varying rates computed by applying a margin (ranging from 1.0-3.5%) over a baseline rate (such as the prime interest rate or LIBOR), depending on the type of borrowing and our fixed charge coverage ratio. In addition, we pay an unused line fee on the facility ranging from 0.5-1.0%, depending on our fixed charge coverage ratio. The revolving credit facility is secured by substantially all of the assets of Interface, Inc. and its domestic subsidiaries (subject to exceptions for certain immaterial subsidiaries), including all of the stock of our domestic subsidiaries and up to 65% of the stock of our first-tier material foreign subsidiaries. The multicurrency loan facility is secured by substantially all of the assets of Interface Europe, Ltd. and its material subsidiaries. Those collateral documents provide that, if an event of default occurs under the revolving credit facility, the lenders’ collateral agent may, upon the request of the specified percentage of lenders, exercise remedies with respect to the collateral that include foreclosing mortgages on our real estate assets, taking possession of or selling our personal property assets, collecting our accounts receivable, or exercising proxies to take control of the pledged stock of our domestic and first-tier material foreign subsidiaries.
On March 30, 2004, we further amended our revolving credit facility. The amendment provided that, for purposes of calculating a specified fixed charge coverage ratio, any interest payments on the Company’s 7.3% senior notes that are due and payable on April 1 or October 1 of a given fiscal year shall, when paid, be deemed to have been paid in the second fiscal quarter and the fourth fiscal quarter, respectively, of such fiscal year.
As of October 3, 2004, $20.1 million in borrowings (which includes $3.9 million of short-term borrowings) and $16.5 million in letters of credit were outstanding under our revolving credit facility. As of October 3, 2004, we could have incurred $50.6 million of additional borrowings under our revolving credit facility.
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NOTE 7 – STOCK-BASED COMPENSATION
We use the intrinsic value method of accounting for employee stock options in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” as allowed under the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” Compensation expense related to stock option plans was not material for the three-month or nine-month periods ended October 3, 2004, and September 28, 2003, respectively.
The following table includes disclosures required by SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” and illustrates the effect on net loss and loss per share as if the Company had applied the fair value recognition provisions of SFAS 123:
The fair value of options at the date of grant was estimated using the Black-Scholes option pricing model.
NOTE 8 – EMPLOYEE BENEFIT PLANS
The following tables provide the components of net periodic benefit cost for the three-month and nine-month periods ended October 3, 2004, and September 28, 2003, respectively:
NOTE 9 — DISCONTINUED OPERATIONS
In the fourth quarter of 2002, management approved and committed to a plan to sell or otherwise create a joint venture or strategic alliance for the Company’s raised/access flooring business. The Company recorded an impairment charge of $12.0 million, net of tax, during the fourth quarter of 2002 to adjust the carrying value of the assets of this business to their estimated fair values. In September 2003, the Company sold the raised/access flooring business and recorded an after-tax loss on disposition of $8.8 million.
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The Company has committed to a plan to exit its owned Re:Source dealer businesses, and in the third quarter 2004 we began to dispose of several of our dealer subsidiaries. In accordance with GAAP, we have therefore reported the results of operations for the owned Re:Source dealer businesses, as well as our small Australian dealer and small residential fabrics businesses that we have also decided to exit, as discontinued operations. In connection with this action, the Company also recorded write-downs for the impairment of assets and goodwill of $17.5 million and $29.0 million, respectively, in the third quarter of 2004.
Information regarding all of the above-described discontinued operations is as follows:
NOTE 10 — SUPPLEMENTAL CONDENSED CONSOLIDATING GUARANTOR FINANCIAL STATEMENTS
The Guarantor Subsidiaries, which consist of the Company’s principal domestic subsidiaries, are guarantors of the Company’s 10.375% senior notes due 2010, its 7.3% senior notes due 2008, and its 9.5% senior subordinated notes due 2014. The Supplemental Guarantor Financial Statements are presented herein pursuant to requirements of the Commission.
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONSFOR THE THREE MONTHS ENDED OCTOBER 3, 2004
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CONDENSED CONSOLIDATING STATEMENT OF OPERATIONSFOR THE NINE MONTHS ENDED OCTOBER 3, 2004
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CONDENSED CONSOLIDATING BALANCE SHEET
OCTOBER 3, 2004
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CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWSFOR THE NINE MONTHSENDED OCTOBER 3, 2004
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NOTE 11 — NEW ACCOUNTING PRONOUNCEMENTS
In December 2003, the Financial Accounting Standards Board (“FASB”) issued a revision to SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This statement does not change the measurement or recognition aspects for pensions and other postretirement benefit plans; however, it does revise employers’ disclosures to include more information about the plan assets, obligations to pay benefits and funding obligations. SFAS 132, as revised, is generally effective for financial statements with fiscal years ending after December 15, 2003. Certain additional disclosures applicable to foreign defined benefit plans are effective for fiscal years ending after June 15, 2004. The adoption of the required provisions of SFAS 132, as revised, did not have a material effect on the Company’s consolidated financial statements. The adoption of the disclosures related to the Company’s foreign defined benefit plans are not expected to have a material effect on the Company’s consolidated financial statements.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS 150 clarifies the definition of a liability as currently defined in FASB Concepts Statement No. 6, “Elements of Financial Statements,” as well as other planned revisions. This statement requires a financial instrument that embodies an obligation of an issuer to be classified as a liability. In addition, the statement establishes standards for the initial and subsequent measurement of these financial instruments and disclosure requirements. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and for all other matters, is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material effect on the Company’s financial position or results of operations.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS 149 amends SFAS No. 133 for decisions made by the FASB’s Derivatives Implementation Group, other FASB projects dealing with financial instruments, and in response to implementation issues raised in relation to the application of the definition of a derivative. This statement is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material effect on the Company’s financial position or results of operations.
In January 2003, the FASB issued Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities” and in December 2003, a revised interpretation was issued (FIN No. 46, as revised). In general, a variable interest entity (“VIE”) is a corporation, partnership, trust, or any other legal structure used for business purposes that either does not have equity investors with voting rights or has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46, as revised, requires a VIE to be consolidated by a company if that company is designated as the primary beneficiary. The interpretation applies to VIEs created after January 31, 2003, and for all financial statements issued after December 15, 2003 for VIEs in which an enterprise held a variable interest that it acquired before February 1, 2003. The adoption of FIN 46, as revised, did not have a material effect on the Company’s financial position or results of operations.
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Our discussions below in this Item 2 are based upon the more detailed discussions about our business, operations and financial condition included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2003, under Item 7. Our discussions here focus on our results during the quarter ended, or as of, October 3, 2004, and the comparable period of 2003 for comparison purposes, and, to the extent applicable, any material changes from the information discussed in that Form 10-K or other important intervening developments or information since that time. These discussions should be read in conjunction with that Form 10-K for more detailed and background information.
Forward-Looking Statements
This report contains statements which may constitute “forward-looking statements” within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended by the Private Securities Litigation Reform Act of 1995. Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements include risks and uncertainties associated with economic conditions in the commercial interiors industry as well as the risks and uncertainties discussed under the heading “Risk Factors” included in the amendment to the Company’s registration statement on Form S-4 filed with the Securities and Exchange Commission on June 28, 2004, which discussion is hereby incorporated by reference. The Company undertakes no obligation to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to future operating results over time.
Discontinued Operations
Over the past few years, our owned Re:Source dealer businesses, which are part of a broader network comprised of both owned and aligned dealers that sell and install floorcovering products, have experienced decreased sales volumes and intense pricing pressure, primarily as a result of the economic downturn in the commercial interiors industry. As a result, we decided to exit our owned Re:Source dealer businesses, and in the third quarter 2004 we began to dispose of several of our dealer subsidiaries. In accordance with GAAP, we have therefore reported the results of operations for the owned
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Re:Source dealer businesses (as well as the results of operations of a small Australia dealer business and a small residential fabrics business that we also decided to exit), for all periods reflected herein, as “discontinued operations”. Consequently, our discussion of revenues or sales and other results of operations (except for net income or loss amounts), including percentages derived from or based on such amounts, excludes these discontinued operations unless we indicate otherwise.
These discontinued operations represented revenues of $34.2 million and $37.6 million in the three-month periods ended October 3, 2004, and September 28, 2003, respectively, and represented revenues of $111.4 million and $110.9 million in the nine-month periods ended October 3, 2004, and September 28, 2003, respectively. Loss from operations of these businesses, net of tax, was $4.1 million and $3.8 million in the three-month periods ended October 3, 2004, and September 28, 2003, respectively, and $9.5 million and $8.1 million in the nine-month periods ended October 3, 2004, and September 28, 2003, respectively. The Company recorded write-downs, net of tax, for the impairment of assets and goodwill of $17.5 million and $29.0 million, respectively, in the third quarter of 2004, to adjust the carrying value of the assets of these businesses to their net realizable value.
Our discussion of revenues or sales and other results of operations (except for net income or loss amounts), including percentages derived from or based on such amounts, also excludes the results of our U.S. raised/access flooring business, which we sold in September 2003 and are included in the reported results for “discontinued operations” for such prior periods. The results of these discontinued operations for the three-month and nine-month periods ended September 28, 2003, yielded after-tax losses of $0.9 million and $3.7 million, respectively. The discontinued operations related to the U.S. raised/access flooring business had no impact for the three-month and nine-month periods ended October 3, 2004.
General
During the quarter ended October 3, 2004, we had net sales of $222.8 million and a net loss of $47.8 million, or $0.92 per diluted share, compared with net sales of $199.5 million and a net loss of $13.4 million, or $0.26 per diluted share, in the comparable period last year. During the first nine months of fiscal 2004 (which was a 40-week period), we had net sales of $649.1 million and a net loss of $51.0 million, or $0.98 per diluted share, compared with net sales of $570.3 million and a net loss of $29.2 million (after giving effect to $4.6 million of pre-tax restructuring charges), or $0.58 per diluted share, in the comparable period last year (which was a 39-week period). Our net losses for the three-month and nine-month periods ended October 3, 2004 (despite increases in both sales and operating income compared with the prior year periods) are the result of the operational losses and write-downs associated with our discontinued operations, as discussed above. The 40 weeks versus the 39 weeks included in the respective 2004 and 2003 nine-month periods are a factor in certain of the comparisons reflected below.
Results of Operations
The following table presents, as a percentage of net sales, certain items included in our Consolidated Statements of Operations for the three-month and nine-month periods ended October 3, 2004, and September 28, 2003, respectively:
Below we provide information regarding net sales for each of our four operating segments, and analyze those results for the three-month and nine-month periods ended October 3, 2004, and September 28, 2003, respectively.
Net Sales by Business Segment
Net sales by operating segment and for our Company as a whole were as follows for the three-month and nine-month periods ended October 3, 2004, and September 28, 2003, respectively:
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In the following discussion of net sales by operating segment, it should be noted that the nine-month period ended October 3, 2004, contained 40 weeks, while the comparable period in 2003 contained 39 weeks, which is a factor in the comparison of results for those periods.
Modular Carpet Segment. For the three-month period ended October 3, 2004, net sales for the Modular Carpet segment increased $16.7 million (13.4%) versus the comparable period in 2003. For the nine-month period ended October 3, 2004 (which was a 40-week period), net sales for the Modular Carpet segment increased $56.6 million (16.0%) versus the comparable period in 2003 (which was a 39-week period). On a geographic basis, we experienced significant increases in net sales in the Americas and in Asia-Pacific for both the three-month period (up 21.4% and 24.1%, respectively) and nine-month period (up 35.5% and 14.6%, respectively) ended October 3, 2004, versus the comparable periods in 2003. Net sales in the European portion of the business were up 0.2% for the three-month period in local currency terms and up 10.3% in U.S. dollars versus the comparable period in 2003. For the nine-month period ended October 3, 2004, European sales were flat in local currency terms and up 9.4% in U.S. dollars versus the comparable period in 2003. We also saw a significant increase in our sales into the education, retail, government and residential market segments in North America, which we attribute to our focus on those market segments, among others, as part of our strategy to increase product sales in non-corporate office market segments. Sales growth in Asia-Pacific is attributable in large part to a relatively good economic climate in that region and to our introduction of a Heuga brand modular carpet line at competitive, mid-level prices.
Bentley Prince Street Segment. In our Bentley Prince Street segment, net sales for the three-month period ended October 3, 2004 increased $3.4 million (11.9%) versus the comparable period in 2003. For the nine-month period ended October 3, 2004, net sales increased $8.6 million (10.9%) versus the comparable period in 2003. These increases were attributable primarily to the improving corporate office market, as well as the success of our market segmentation strategy, particularly in the retail, education and hospitality market segments.
Fabrics Group Segment. For the three-month period ended October 3, 2004, net sales for our Fabrics Group segment increased $2.1 million (4.8%) versus the comparable period in 2003. For the nine-month period ended October 3, 2004, net sales increased $11.5 million (8.9%) versus the comparable period in 2003. These increases were attributable primarily to the improving corporate office market.
Specialty Products Segment. For the three-month period ended October 3, 2004, net sales for our Specialty Products segment increased $1.1 million (58.5%) versus the comparable period in 2003. For the nine-month period ended October 3, 2004, net sales increased $2.0 million (28.1%) versus the comparable period in 2003. These increases were attributable primarily to the improving corporate office market.
Cost and Expenses
Company Consolidated. The following table presents, on a consolidated basis for our operations, our overall cost of sales and selling, general and administrative expenses for the three-month and nine-month periods ended October 3, 2004, and September 28, 2003, respectively:
For the three-month period ended October 3, 2004, our cost of sales increased $15.2 million (10.7%) versus the comparable period in 2003, primarily due to increased product ($10.1 million) and labor ($1.0 million) costs associated with increased production levels during the third quarter of 2004. Our raw materials costs in the third quarter 2004 were up between 1-2% versus the same period in 2003, primarily due to increased prices for petrochemical products. In addition, the translation of Euros into U.S. dollars resulted in an
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approximately $2.3 million increase in the cost of goods sold during the third quarter 2004 compared with the same period in 2003. As a percentage of net sales, cost of sales decreased to 70.6% for the quarter ended October 3, 2004, versus 71.2% for the comparable period in 2003. The percentage decrease was primarily due to (1) the increased absorption of fixed manufacturing costs as a result of improved sales volume, accounting for approximately 75% of the percentage decrease, and (2) the realization of the success of our restructuring initiatives which continue to strengthen and streamline operations throughout the global organization, accounting for approximately 10% of the percentage decrease.
For the nine-month period ended October 3, 2004 (which was a 40-week period), our cost of sales increased $45.3 million (11.1%) versus the comparable period in 2003 (which was a 39-week period), primarily due to increased product ($30.2 million) and labor ($5.9 million) costs associated with increased production levels during the first nine months of 2004. Our raw materials costs in the first nine months of 2004 were up between 1-2% versus the same period in 2003, primarily due to increased prices for petrochemical products. In addition, the translation of Euros into U.S. dollars resulted in an approximately $8.8 million increase in the cost of goods sold during the nine-month period in 2004 compared with the same period in 2003. As a percentage of net sales, cost of sales decreased to 69.6% for the nine-month period ended October 3, 2004, versus 71.3% for the comparable period in 2003. The percentage decrease was primarily due to (1) the increased absorption of fixed manufacturing costs as a result of improved sales volume, accounting for approximately 60% of the percentage decrease, and (2) the realization of the success of our restructuring initiatives which continue to strengthen and streamline operations throughout the global organization, accounting for approximately 15% of the percentage decrease.
For the three-month period ended October 3, 2004, our selling, general and administrative expenses increased $3.4 million (7.3%) versus the comparable period in 2003. The primary components of this increase were: (1) $1.0 million of performance bonuses paid in the third quarter of 2004 that were not paid in the third quarter of 2003; (2) $1.3 million in commission payments due to the increased level of sales in the third quarter 2004; and (3) $1.1 million due to currency fluctuations (primarily the movement of the Euro). As a percentage of net sales, selling, general and administrative expenses decreased to 22.3% for the quarter ended October 3, 2004, versus 23.2% for the comparable period in 2003. The percentage decrease was primarily due to (1) the increased absorption of the fixed portion of administrative costs as a result of improved sales volume, accounting for approximately 75% of the percentage decrease, and (2) the realization of the success of our restructuring initiatives which continue to strengthen and streamline operations throughout the global organization, accounting for approximately 15% of the percentage decrease.
For the nine-month period ended October 3, 2004, our selling, general and administrative expenses increased $11.9 million (8.5%) versus the comparable period in 2003. The primary components of this increase were: (1) $5.6 million in commission payments due to the increased level of sales in the first nine months of 2004; (2) $4.4 million due to currency fluctuations (primarily the movement of the Euro); (3) $4.3 million of performance bonuses paid in the first nine months of 2004 that were not paid in the first nine months of 2003; and (4) $1.0 million of extra administrative costs due to the 40-week period in the first nine months of 2004 versus a 39-week period in the first nine months of 2003. As a percentage of net sales, selling, general and administrative expenses decreased to 23.4% for the nine-month period ended October 3, 2004, versus 24.5% for the comparable period in 2003. The percentage decrease was primarily due to (1) the increased absorption of the fixed portion of administrative costs as a result of improved sales volume, accounting for approximately 80% of the percentage decrease, and (2) the realization of the success of our restructuring initiatives which continue to strengthen and streamline operations throughout the global organization, accounting for approximately 10% of the percentage decrease.
Cost and Expenses by Segment. The following table presents the combined cost of sales and selling, general and administrative expenses for each of our operating segments:
Interest Expenses
For the three-month period ended October 3, 2004, interest expense increased $0.4 million to $11.4 million, versus $11.0 million in the comparable period in 2003. For the nine-month period ended October 3, 2004, interest expense increased $3.4 million to $34.8 million, versus $31.4 million in the comparable period in 2003. This increase was due primarily to (1) increased borrowings during each of the first
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three quarters of 2004 to support increased working capital levels as a result of improved sales volume during the period, and (2) a higher overall borrowing rate of interest versus the comparable period in 2003.
Liquidity and Capital Resources
At October 3, 2004, we had $19.7 million in cash, and we had $20.1 million in borrowings (which includes $3.9 million of short-term borrowings) and $16.5 million in letters of credit outstanding under our revolving credit facility. As of October 3, 2004, we could have incurred $50.6 million of additional borrowings under our revolving credit facility.
Analysis of Cash Flows
Our primary sources of cash during the nine-month period ended October 3, 2004, were (1) $16.1 million of additional domestic borrowings under our revolving credit facility, (2) $7.6 million of net proceeds (after payment of fees, expenses and redemption, including accrued interest, of our 9.5% senior subordinated notes due 2005) from the issuance of our 9.5% senior subordinated notes due 2014, (3) $5.7 million received from the sale of certain discontinued operations, and (4) $1.7 million from the issuance of common stock associated with the exercise of employee stock options. The primary uses of cash for the nine months ended October 3, 2004 were (1) $26.9 million associated with the reduction of current liabilities, (2) $11.5 million for additions to property and equipment in our manufacturing facilities, (3) $3.7 million from increases in accounts receivable, (4) $3.3 million related to an increase in inventory levels, and (5) $2.2 million of other investing primarily associated with deposits and other non-current expenditures.
The Company estimates the future cash expenditures related to its plan to exit its owned Re:Source dealer businesses (as well as a few additional small businesses as described above) to be $10 million, primarily for funding future losses and for potentially continuing lease obligations and potential severance benefits. Such cash expenditures are expected to be offset by the realization of approximately $25 million of working capital proceeds associated with the exit activities. The Company expects the exit activities to be substantially completed by the end of the second quarter of 2005.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our discussion below in this Item 3 is based upon the more detailed discussions of our market risk and related matters included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2003, under Item 7A. Our discussion here focuses on the quarter ended October 3, 2004, and any material changes from (or other important intervening developments since the time of) the information discussed in that Form 10-K. This discussion should be read in conjunction with that Form 10-K for more detailed and background information.
At October 3, 2004, we recognized a $0.8 million decrease in our foreign currency translation adjustment account compared to December 28, 2003, primarily because of the weakening of the U.S. dollar against the Euro.
Sensitivity Analysis. For purposes of specific risk analysis, we use sensitivity analysis to measure the impact that market risk may have on the fair values of our market sensitive instruments.
To perform sensitivity analysis, we assess the risk of loss in fair values associated with the impact of hypothetical changes in interest rates and foreign currency exchange rates on market sensitive instruments. The market value of instruments affected by interest rate and foreign currency exchange rate risk is computed based on the present value of future cash flows as impacted by the changes in the rates attributable to the market risk being measured. The discount rates used for the present value computations were selected based on market interest and foreign currency exchange rates in effect at October 3, 2004. The values that result from these computations are compared with the market values of these financial instruments at October 3, 2004. The differences in this comparison are the hypothetical gains or losses associated with each type of risk.
As of October 3, 2004, based on a hypothetical immediate 150 basis point increase in interest rates, with all other variables held constant, the market value of our fixed rate long-term debt would be impacted by a net decrease of approximately $28.8 million. Conversely, a 150 basis point decrease in interest rates would result in a net increase in the market value of our fixed rate long-term debt of approximately $28.4 million.
As of October 3, 2004, a 10% decrease or increase in the levels of foreign currency exchange rates against the U.S. dollar, with all other variables held constant, would result in a decrease in the fair value of our financial instruments of $5.4 million or an increase in the fair value of our financial instruments of $4.4 million, respectively. As the impact of offsetting changes in the fair market value of our net foreign investments is not included in the sensitivity model, these results are not indicative of our actual exposure to foreign currency exchange risk.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation was performed under the supervision and with the participation of our management, including our President and Chief Executive Officer and our Vice President and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Act”), pursuant to Rule 13a-14(c) under the Act. Based on that evaluation, our President and Chief Executive Officer and our Vice President and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report.
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PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are not aware of any material pending legal proceedings involving us, or any of our subsidiaries or any of our property. We are from time to time a party to litigation arising in the ordinary course of business.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS
The following exhibits are filed with this report:
SIGNATURE
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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