UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20459
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005 or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 333-115587
NORTH ATLANTIC HOLDING COMPANY, INC.
------------------------------------------------------
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 20-0709285
------------------------------- ------------------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
257 Park Avenue South, New York, New York 10010-7304
------------------------------------------- ------------------
(Address of Principal Executive Offices) (Zip Code)
(212) 253-8185
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(Registrant's Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ].
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [ X].
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes [ ] No [X].
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date: 589,176 shares of common stock,
$.01 par value, as of November 12, 2005.
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands except share data)
(unaudited)
December 31,
2004
September 30, As Restated,
2005 Note 1
---------------- ---------------
Current assets:
Cash $ 4,582 $ 2,347
Accounts receivable, net 7,431 7,839
Inventories 33,500 37,959
Other current assets 4,041 5,861
---------------- ---------------
Total current assets 49,554 54,006
Property, plant and equipment, net 14,190 10,771
Deferred financing costs, net 13,096 13,105
Goodwill 128,697 128,697
Other intangible assets, net 9,962 10,293
Other assets 18,011 15,526
---------------- ---------------
Total assets $ 233,510 $ 232,398
================ ===============
Current liabilities:
Accounts payable $ 5,253 $ 7,005
Accrued expenses 6,639 4,642
Accrued interest expense 1,738 6,274
Deferred income taxes 4,141 4,801
Revolving credit facility - 14,500
---------------- ---------------
Total current liabilities 17,771 37,222
Senior notes and long-term debt 272,790 266,622
Term loan 30,000 -
Deferred income taxes 5,869 5,005
Postretirement benefits 6,471 6,061
Pension benefits and other long-term liabilities 3,293 4,013
---------------- ---------------
Total liabilities 336,194 318,923
---------------- ---------------
Stockholder's equity:
Common stock, voting, $.01 par value authorized shares,
750,000; issued shares, 591,343, outstanding shares, 589,176,
shares held in treasury, 2,167 in 2005; and issued and
outstanding, 591,343 in 2004 6 6
Additional paid-in capital 5,381 5,291
Loans to stockholders for stock purchase (97) (99)
Accumulated other comprehensive income (loss) (1,364) (1,351)
Accumulated deficit (106,610) (90,372)
---------------- ---------------
Total stockholders' equity (deficit) (102,684) (86,525)
---------------- ---------------
Total liabilities and stockholders' deficit $ 233,510 $ 232,398
================ ===============
The accompanying notes are an integral part of the
condensed consolidated financial statements.
2
NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share amounts)
(unaudited)
Three months Three months
Ended Ended
September 30, 2005 September 30, 2004
-------------------- --------------------
Net sales $ 28,847 $ 30,741
Cost of sales 14,204 13,775
-------------------- --------------------
Gross profit 14,643 16,966
Selling, general and administrative expenses 8,564 5,666
Restructuring charges 853 -
-------------------- --------------------
Operating income (loss) 5,226 11,300
Interest expense and financing costs, net 7,781 7,282
Other expense 851 (5,550)
-------------------- --------------------
Income (loss) before income tax expense (benefit) (3,406) 9,568
Income tax expense (benefit) 572 3,636
-------------------- --------------------
Net income (loss) applicable to common shares $ (3,978) $ 5,932
==================== ====================
Basic earnings per common share:
Net income (loss) applicable to common shares $ (6.75) $ 10.03
==================== ====================
Diluted earnings per common share:
Net income (loss) applicable to common shares $ (6.75) $ 8.25
==================== ====================
Weighted average common shares outstanding:
Basic 589.3 591.3
Diluted 589.3 718.9
The accompanying notes are an integral part of the
condensed consolidated financial statements.
3
NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands except per share amounts)
(unaudited)
Nine months Nine months
Ended Ended
September 30, 2005 September 30, 2004
-------------------- --------------------
Net sales $ 86,716 $ 90,053
Cost of sales 42,466 43,094
-------------------- --------------------
Gross profit 44,250 46,959
Selling, general and administrative expenses 29,393 27,032
Restructuring charges 4,920 -
-------------------- --------------------
Operating income (loss) 9,937 19,927
Interest expense and financing costs, net 23,149 24,301
Other expense 2,451 (5,037)
-------------------- --------------------
Income (loss) before income tax expense (benefit) (15,663) 663
Income tax expense (benefit) 575 252
-------------------- --------------------
Net income (loss) (16,238) 411
Preferred stock dividends - (1,613)
-------------------- --------------------
Net income (loss) applicable to common shares $ (16,238) $ (1,202)
==================== ====================
Basic and Diluted earnings per common share:
Net income (loss) $ (27.55) $ 0.72
Preferred stock dividends - (2.81)
-------------------- --------------------
Net income (loss) applicable to common shares $ (27.55) $ (2.10)
==================== ====================
Common stock dividends $ - $ 4,884
==================== ====================
Basic and Diluted earnings per common share:
Common stock dividends $ - $ 8.25
==================== ====================
Weighted average common shares outstanding:
Basic 589.3 573.2
Diluted 589.3 573.2
The accompanying notes are an integral part of the
condensed consolidated financial statements.
4
NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(unaudited)
Three months Three months
Ended Ended
September 30, 2005 September 30, 2004
-------------------- --------------------
Net income (loss) $ (3,978) $ 5,932
Other comprehensive income:
Unrealized hedging gains (losses) (13) -
-------------------- --------------------
Comprehensive income (loss) $ (3,991) $ 5,932
==================== ====================
Nine months Nine months
Ended Ended
September 30, 2005 September 30, 2004
-------------------- --------------------
Net income (loss) $ (16,238) $ 411
Other comprehensive income:
Unrealized hedging gains (losses) (13) -
-------------------- --------------------
Comprehensive income (loss) $ (16,251) $ 411
==================== ====================
The accompanying notes are an integral part of the
condensed consolidated financial statements.
5
NORTH ATLANTIC HOLDING COMPANY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine months Nine months
Ended Ended
September 30, 2005 September 30, 2004
--------------------- -------------------
Cash flows from operating activities:
Net income (loss) $ (16,238) $ 411
Adjustments to reconcile net income (loss)
to net cash provided by (used in) operating activities:
Loss on disposal of equipment 600 -
Other comprehensive income (13)
Depreciation 655 646
Amortization of other intangible assets 331 448
Amortization of deferred financing costs 1,817 1,658
Amortization of interest on senior discount notes 6,168 4,620
Deferred income taxes 204 (227)
Stock compensation expense 90 -
Changes in operating assets and liabilities:
Accounts receivable, net 408 176
Inventories 4,459 (924)
Other current assets 1,820 (6,165)
Other assets (2,485) (4,489)
Accounts payable (1,752) (2,988)
Accrued expenses and other (2,539) (21)
Accrued pension liabilities & other long-term (720) (2,260)
Accrued postretirement liabilities 410 (1,830)
--------------------- -------------------
Net cash provided by (used in) operating activities (6,785) (10,945)
--------------------- -------------------
Cash flows from investing activities:
Net additions to plant, property and equipment (4,674) (1,288)
--------------------- -------------------
Net cash provided by (used in) investing activities (4,674) (1,288)
--------------------- -------------------
Cash flows from financing activities:
Proceeds from term loan 30,000 -
Proceeds (payments) from (to) revolving credit facility (14,500) 28,500
Proceeds from issuance of new senior notes - 200,000
Proceeds from issuance of senior discount notes - 60,010
Payment of old senior notes - (155,000)
Payment of financing costs (1,808) (10,032)
Payments on notes payable - (30,686)
Redemption of preferred stock - (65,080)
Preferred stock cash dividends - (1,613)
Proceeds from issuance of common stock - 1
Common stock cash dividend - (4,884)
Loan repayments from stockholders for stock purchases 2 -
--------------------- -------------------
Net cash provided by (used in) financing activities 13,694 21,216
--------------------- -------------------
Net increase (decrease) in cash 2,235 8,983
Cash, beginning of period 2,347 304
--------------------- -------------------
Cash, end of period $ 4,582 $ 9,287
===================== ===================
The accompanying notes are an integral part of
the condensed consolidated financial statements.
6
North Atlantic Holding Company, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
1. RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS
North Atlantic Holding Company, Inc. (the "Company") previously restated its
consolidated financial statements to correct an error in accounting for income
taxes. During the fourth quarter of 2004, the Company and its subsidiaries
provided a full valuation allowance against its net deferred tax assets.
Following a review of the Company's deferred tax assets and deferred tax
liabilities, the Company determined that in calculating the valuation allowance,
deferred tax liabilities relating to inventories and tax-deductible goodwill had
been inappropriately netted against certain deferred tax assets. It cannot be
determined that the temporary differences related to inventories and goodwill
will reverse during the time period in which the Company's temporary differences
related to its deferred tax assets are expected to reverse or expire. Therefore,
these deferred tax liabilities should not have been utilized to reduce the
amount of the valuation allowance against deferred tax assets. This resulted in
an understatement of the valuation allowance in the amount of these deferred tax
liabilities of $9.8 million and $10.0 million as of December 31, 2004 and March
31, 2005, respectively, and an understatement of income tax expense of $9.8
million and $0.2 million for the year ended December 31, 2004 and for the three
months ended March 31, 2005, respectively. The correction of this understatement
has the effect of increasing deferred tax liabilities, increasing accumulated
deficit and decreasing net income, with no effect on net cash flows, as of and
for the year ended December 31, 2004 and as of and for the three months ended
March 31, 2005.
The following table represents the effect of the restatement on the Company's
Consolidated Balance Sheet as of December 31, 2004:
CONSOLIDATED BALANCE SHEET AS OF DECEMBER 31, 2004
--------------------------------------------------
As Previously
Reported Adjustment As Restated
----------------- ---------------- ----------------
Deferred income taxes - current $ - $ 4,801 $ 4,801
Deferred income taxes - non-current $ - $ 5,005 $ 5,005
Accumulated deficit $ (80,566) $ (9,806) $ (90,372)
2. ORGANIZATION
These condensed consolidated financial statements should be read in conjunction
with the financial statements and related notes thereto included in the
Company's Annual Report on Form 10-K, as amended, for the year ended December
31, 2004.
The accompanying condensed consolidated financial statements are presented in
accordance with the requirements of Form 10-Q and, accordingly, do not include
all the disclosures normally required by generally accepted accounting
principles. The condensed consolidated financial statements have been prepared
in accordance with the Company's customary accounting practices and have not
been audited. In the opinion of management, all adjustments necessary to fairly
present the results of operations for the reported interim periods have been
recorded and were of a normal and recurring nature. The year-end balance sheet
data, as restated and described in Note 1 above, was derived from audited
financial statements, but does not include all disclosures required by generally
accepted accounting principles.
7
On February 9, 2004, North Atlantic Trading Company, Inc., a Delaware
corporation ("NATC"), consummated a holding company reorganization whereby the
Company became the parent company of NATC. The holding company reorganization
was effected pursuant to an Agreement and Plan of Merger (the "Merger
Agreement"), dated February 9, 2004, among the Company, NATC and NATC Merger
Sub, Inc., a Delaware corporation and a direct wholly-owned subsidiary of the
Company ("Merger Sub").
Pursuant to the Merger Agreement, (i) Merger Sub was merged with and into NATC
(the "Merger"), with NATC as the surviving corporation; (ii) NATC became a
wholly-owned subsidiary of the Company; (iii) each of the 539,235 issued and
outstanding shares of voting common stock of NATC, par value $0.01 per share,
was converted into the right to receive one share of common stock of the
Company, par value $0.01 per share ("Company Common Stock"); (iv) each issued
and outstanding share of common stock of Merger Sub was converted into one
issued and outstanding share of common stock of NATC, par value $0.01 per share
("NATC Common Stock"); and (v) all of the issued and outstanding shares of the
Company's Common Stock held by NATC were cancelled.
Immediately after the Merger, (i) 539,235 shares of Company Common Stock were
issued and outstanding; and (ii) ten (10) shares of NATC Common Stock were
issued and outstanding.
Subsequently, the Company issued 49,523 shares of Company Common Stock upon the
exercise of certain warrants pursuant to a Warrant Agreement (the "Warrant
Agreement"), dated June 25, 1997, between the Company (as assignee to NATC's
rights and obligations under the Warrant Agreement) and The Bank of New York, as
warrant agent (as successor to the United States Trust Company of New York). As
of September 30, 2005, (i) 591,343 shares of Company Common Stock were issued
and 589,176 were outstanding; and (ii) ten (10) shares of NATC Common Stock were
issued and outstanding.
3. RECAPITALIZATION AND REORGANIZATION
On February 9, 2004, NATC consummated its general corporate reorganization in
which the Company was created and became the parent company of NATC. On February
17, 2004, NATC consummated the refinancing of its existing debt and preferred
stock and the Company issued senior discount notes in conjunction with the
refinancing. The refinancing consisted principally of (1) the offering and sale
of $200.0 million principal amount of 9 1/4% senior notes due 2012 by NATC (the
"New Senior Notes"), (2) the entering into by NATC of an amended and restated
loan agreement (the "Old Credit Agreement") that provided a $50.0 million senior
secured revolving credit facility (the "Senior Revolving Credit Facility") to
NATC (see Note 8 for a discussion of the refinancing of the Senior Revolving
Credit Facility), and (3) the concurrent offering and sale of $97.0 million
aggregate principal amount at maturity of 12 1/4% senior discount notes due 2014
of the Company (the "Company Notes"). Both the New Senior Notes and the Company
Notes were offered pursuant to Rule l44A and Regulation S and subsequently
registered under the Securities Act of 1933, as amended.
8
Concurrently with the closing of the refinancing, NATC also called for the
redemption of all its outstanding 11% senior notes due 2004 (the "Old Senior
Notes"), in accordance with the terms of the indenture governing such notes, at
the applicable redemption price of 100.0% of the principal amount of $155.0
million, plus interest accrued to the redemption date of April 2, 2004.
The proceeds from the offering of the New Senior Notes, along with borrowings
under the Senior Revolving Credit Facility (see Notes 7 and 8) and the proceeds
from the concurrent offering of the Company Notes were used to (1) repay $36.6
million in outstanding borrowings under the existing senior credit facility (the
"Old Senior Credit Facility"), including borrowings used to finance the cash
purchase price for the acquisition of Stoker, Inc., (2) redeem the Old Senior
Notes, (3) redeem NATC's existing 12% senior exchange payment-in-kind preferred
stock on March 18, 2004, (4) pay a $4.9 million pro rata distribution to
stockholders of the Company and make a distribution to certain holders of
warrants of the Company, (5) make $2.1 million in incentive payments to certain
key employees and outside directors, and (6) pay fees and expenses of $12.8
million incurred in connection with the offerings.
4. RESTRUCTURING
In January 2005, the Company engaged the management consulting firm of Alvarez
and Marsal, LLC ("A&M") to identify the potential for performance improvement
opportunities and to provide for the services of Douglas P. Rosefsky as Chief
Financial Officer.
In April 2005, the Company appointed Douglas P. Rosefsky (formerly Chief
Financial Officer) as President and Chief Executive Officer, Thomas F. Helms,
Jr. (formerly Chairman of the Board of Directors, President and Chief Executive
Officer) as Executive Chairman of the Board of Directors, and Brian C. Harriss
as Chief Financial Officer.
In June 2005, NATC appointed Lawrence S. Wexler (President of the Company's
North Atlantic Cigarette Company, Inc., subsidiary) as Chief Operating Officer.
For the nine months ended September 30, 2005, total restructuring charges
amounted to approximately $4.9 million, including, but not limited to, severance
and separation expenses, A&M fees and other non-recurring expenses. The Company
anticipates incurring additional expenses relating to the restructuring during
the remainder of 2005 and 2006.
5. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION: For the three and nine months ended September 30, 2005,
the condensed consolidated financial statements include the accounts of the
Company and its subsidiaries. For the three and nine months ended September 30,
2004, the condensed consolidated statement of operations includes the accounts
of the Company from inception (February 9, 2004) through September 30, 2004 and
the accounts of NATC and its subsidiaries for January 1, 2004 through September
30, 2004. All significant intercompany accounts have been eliminated.
9
REVENUE RECOGNITION: The Company recognizes revenues and the related costs upon
transfer of title and risk of loss to the customer.Shipping Costs: The Company
records shipping costs incurred as a component of selling, general and
administrative expenses. Shipping costs incurred were $0.7 million and $0.9
million for the three months ended September 30, 2005 and 2004, respectively,
and $3.0 million and $2.6 million for the nine months ended September 30, 2005
and 2004, respectively.
FINANCIAL INSTRUMENTS: The Company enters into foreign currency forward
contracts to hedge a portion of its exposure to changes in foreign currency
exchange rates on inventory purchase commitments. The Company accounts for its
forward contracts under the provisions of Statement of Financial Accounting
Standards No. 133 (SFAS 133), "Accounting for Derivative Instruments and Hedging
Activities." The Company may hedge up to eighty percent of its anticipated
purchases of inventory under the Bollore, S.A. master contract, denominated in
Euros, over a forward period not to exceed twelve months. The Company may also,
from time to time, hedge up to ninety percent of its non-inventory purchases in
the denominated invoice currency. Forward contracts that qualify as hedges are
adjusted to their fair value through other comprehensive income as determined by
market prices on the measurement date. As of September 30, 2005, the adjustment
to record the decrease in fair value relating to the forward contracts amounted
to $13,000 and is recorded as other comprehensive income. Gains and losses on
these contracts are transferred from other comprehensive income into net income
as the related inventories are sold. Changes in fair value of any contracts that
do not qualify for hedge accounting or are not designated as hedges are
recognized in income currently.
MASTER SETTLEMENT AGREEMENT ESCROW ACCOUNT: Pursuant to the Master Settlement
Agreement (the "MSA") entered into in November 1998 by most states (represented
by their attorneys general acting through the National Association of Attorneys
General) and subsequent states' statutes, a "cigarette manufacturer" (which is
defined to include a manufacturer of make-your-own cigarette tobacco) has the
option of either becoming a signatory to the MSA or opening, funding, and
maintaining an escrow account to have funds available for certain potential
tobacco-related liabilities, with sub-accounts on behalf of each settling state.
The Company has chosen to open and fund an escrow account as its method of
compliance. It is the Company's policy to record amounts on deposit in the
escrow account for prior years, as well as cash-on-hand to fund its projected
deposit based on its monthly sales for the current year, as an Other non-current
asset. Each year's obligation is required to be deposited in the escrow account
by April 15 of the following year. During April 2005, approximately $3.4 million
relating to 2004 sales was deposited. As of September 30, 2005 and December 31,
2004, the Company has recorded approximately $16.4 million and $13.2 million,
respectively, in Other assets. For the nine months ended September 30, 2005,
approximately $2.5 million relating to 2005 sales was recorded in Other assets.
6. INVENTORIES
Inventories are stated at the lower of cost or market. Cost is determined on the
last-in, first-out ("LIFO") method for approximately 96% of the inventories.
Leaf tobacco is presented in current assets in accordance with standard industry
practice, notwithstanding the fact that such tobaccos are carried longer than
one year for the purpose of curing.
10
For the three and nine months ended September 30, 2005, inventory quantities
were reduced. This reduction resulted in a liquidation of LIFO inventory
quantities carried at higher costs prevailing in prior years as compared with
the cost of 2005 purchases, the effect of which increased cost of goods sold and
decreased net income by approximately $0.3 million and $1.0 million,
respectively, as compared to $0.9 million and $0.5 million for the three and
nine months ended September 30, 2004, respectively.
The components of inventories are as follows (in thousands):
9/30/2005 12/31/04
-------------- -------------
Raw materials and work in process $ 3,738 $ 4,246
Leaf tobacco 6,714 7,878
Finished goods - loose leaf tobacco 3,373 3,069
Finished goods - MYO products 7,486 8,539
Other 1,900 2,163
-------------- -------------
23,211 25,895
LIFO reserve 10,289 12,064
-------------- -------------
$ 33,500 $ 37,959
============== =============
7. COMPANY NOTES AND NEW SENIOR NOTES
The outstanding amounts of the Company Notes and New Senior Notes are as follows
(in thousands):
9/30/2005 12/31/04
-------------- -------------
Company Notes $ 72,790 $ 66,622
New Senior Notes 200,000 200,000
-------------- -------------
$ 272,790 $ 266,622
============== =============
On February 17, 2004, NATC consummated the refinancing of its existing debt and
preferred stock. The refinancing consisted principally of (1) the offering and
sale of the New Senior Notes, (2) entering into the Senior Revolving Credit
Facility, (3) the concurrent sale of the Company Notes and (4) the repayment of
$30.7 million in debt relating principally to the acquisition of Stoker, Inc.
The New Senior Notes are senior unsecured obligations of NATC, which has no
independent assets or operations, and will mature on March 1, 2012. The New
Senior Notes bear interest at the rate of 9 1/4% per annum, payable semiannually
on March 1 and September 1 of each year, commencing on September 1, 2004. Each
of NATC's existing subsidiaries jointly, severally and fully and unconditionally
guarantees the New Senior Notes on a senior unsecured basis. Each of NATC's
future subsidiaries (other than those designated unrestricted subsidiaries) will
jointly and severally guarantee the New Senior Notes on a senior unsecured
basis. NATC is not required to make mandatory redemptions or sinking fund
payments prior to the maturity of the New Senior Notes. The Company or NATC may,
from time to time, seek to retire all or a portion of the New Senior Notes
through cash purchases and/or exchanges for other securities in open market
purchases, privately negotiated transactions or otherwise.
11
On and after March 1, 2008, the New Senior Notes will be redeemable, at NATC's
option, in whole at any time or in part from time to time, upon not less than 30
nor more than 60 days prior notice at the following redemption prices (expressed
in percentages of principal amount), if redeemed during the 12-month period
commencing March 1 of the years set forth below, plus accrued and unpaid
interest to the redemption date (subject to the right of holders of record on
the relevant record date to receive interest due on the relevant interest
payment date):
Year Redemption Price
---- ----------------
2008 104.625%
2009 102.313%
2010 and thereafter 100.000%
In addition, prior to March 1, 2008, NATC may redeem the New Senior Notes, at
its option, in whole at any time or in part from time to time, upon not less
than 30 nor more than 60 days prior notice at a redemption price equal to 100%
of the principal amount of the New Senior Notes redeemed plus a "make-whole"
premium based on U.S. Treasury rates as of, and accrued and unpaid interest to,
the applicable redemption date.
Further, at any time prior to March 1, 2007, NATC may, at its option, redeem up
to 35% of the aggregate principal amount of the New Senior Notes with the net
cash proceeds of one or more equity offerings by the Company or NATC, at its
option, subject to certain conditions, at a redemption price equal to 109.250%
of the principal amount thereof, plus accrued and unpaid interest thereon, if
any, to the date of redemption; provided, however, that after any such
redemption at least 65% of the aggregate principal amount of the New Senior
Notes remains outstanding. In order to affect the foregoing redemption with the
proceeds of any equity offering, NATC shall make such redemption not more than
60 days after the consummation of any such equity offering.
Concurrently with the offering of the New Senior Notes, the Company issued $97.0
million aggregate amount at maturity of the Company Notes. Proceeds of
approximately $53.8 million from this issuance were used to make a capital
contribution to NATC. The Company Notes are the Company's senior obligations and
are unsecured. Prior to March 1, 2008, interest will accrue on the Company Notes
in the form of an increase in the accreted value of the Company Notes.
Thereafter, cash interest on the Company Notes will accrue and be payable
semi-annually in arrears on March 1 and September 1, commencing on September 1,
2008, at a rate of 12 1/4% per annum. The Company Notes were issued with an
initial accreted value of $618.66 per $1,000 principal amount of maturity of
Company Notes. The accreted value of each Company Note will increase from the
date of issuance until March 1, 2008, at a rate of 12 1/4% per annum, compounded
semi-annually reflecting the accrual of non-cash interest, such that the
accreted value will equal the principal amount at maturity of each Company Note
on March 1, 2008. The Company Notes are not guaranteed by NATC or any of its
subsidiaries and are structurally subordinated to all of NATC's and its
subsidiaries' obligations, including the New Senior Notes and the Financing
Agreement (see Note 8). The Company is not required to make mandatory
redemptions or sinking fund payments prior to the maturity of the Company Notes.
12
On and after March 1, 2009, the Company Notes will be redeemable, at the
Company's option, in whole at any time or in part from time to time, upon not
less than 30 nor more than 60 days prior notice at the following redemption
prices (expressed in percentages of principal amount at maturity), if redeemed
during the 12-month period commencing March 1 of the years set forth below, plus
accrued and unpaid interest to the redemption date (subject to the right of
holders of record on the relevant record date to receive interest due on the
relevant interest payment date):
Year Redemption Price
---- ----------------
2009 106.125%
2010 104.083%
2011 102.042%
2012 and thereafter 100.000%
In addition, prior to March 1, 2009, the Company may redeem the Company Notes,
at its option, in whole at any time or in part from time to time, upon not less
than 30 nor more than 60 days prior notice at a redemption price equal to 100%
of the accreted value of the Company Notes redeemed plus a "make-whole" premium
based on U.S. Treasury rates as of, and accrued and unpaid interest to, the
applicable redemption date.
Further, at any time prior to March 1, 2007, the Company may, at its option,
redeem up to 35% of the aggregate principal amount at maturity of the Company
Notes with the net cash proceeds of one or more equity offerings by the Company
or NATC, subject to certain conditions, at a redemption price equal to 112.250%
of the accreted value thereof, plus accrued and unpaid interest thereon, if any,
to the date of redemption; provided, however, that after any such redemption at
least 65% of the aggregate principal amount at maturity of the Company Notes
remains outstanding. In order to affect the foregoing redemption with the
proceeds of any equity offering, the Company shall make such redemption not more
than 60 days after the consummation of any such equity offering.
On October 6, 2005, NATC purchased Company Notes with an accreted book value of
approximately $22.1 million (face value at maturity of approximately $29.5
million) for approximately $6.3 million in cash. The Company or NATC may, from
time to time, continue to acquire and/or retire all or a portion of the Company
Notes and/or New Senior Notes through cash purchases and/or exchanges for other
securities in open market purchases, privately negotiated transactions or
otherwise.
The Company is dependent on NATC's cash flows to service its debt. The amount of
cash interest to be paid by the Company to third parties during the next five
years is as follows: $0 in each of 2005, 2006, 2007 and March 1, 2008; $4,137
payable on September 1, 2008 and $4,137 payable on each of March 1 and September
1 thereafter, until maturity.
8. FINANCING AGREEMENT
On June 16, 2005, NATC refinanced its existing $35.0 million Amended and
Restated Loan Agreement, dated as of February 17, 2004, by entering into a
Financing Agreement (the "Financing Agreement") with various financial
institutions ("Lenders") and Fortress Credit Corp., as agent for the Lenders
("Agent'). The Financing Agreement consists of a $30.0 million term loan
facility and a $55.0 million revolving credit facility, and includes a letter of
credit sublimit of $10.0 million (collectively, the "Credit Facility"). As of
13
September 30, 2005, NATC had not borrowed any monies under the revolving credit
facility. The Credit Facility will mature on June 30, 2010, and does not provide
for any amortization of the term loan prior to maturity. NATC will use the
revolving credit facility for working capital requirements and other general
corporate purposes. Indebtedness under the Financing Agreement is guaranteed by
the Company and each of NATC's current and future subsidiaries, and is secured
by a first perfected lien on substantially all of the Company's and its direct
and indirect subsidiaries' current and future assets and property. The
collateral includes a pledge by the Company of its equity interest in NATC and a
first priority lien on all equity interests and intercompany notes held by NATC
and its direct and indirect subsidiaries.
Loans and advances under the Financing Agreement bear interest at a variable
rate based on either the prime rate or LIBOR, at NATC's option, plus a specified
margin ranging from 1.00% to 3.75% in case of prime rate indebtedness, and from
3.50% to 6.25% in the case of LIBOR indebtedness, based on the sum of NATC's
secured indebtedness in relation to its EBITDAR, as defined in the Financing
Agreement. As of September 30, 2005, the interest rate on NATC's term loan was
7.2%.
NATC paid the Lenders a closing fee of $1.275 million and is required to pay the
Agent a quarterly servicing fee in the amount of $25,000. Under the revolving
credit facility, NATC is required to pay the Lenders an annual commitment fee in
an amount equal to 0.50% of the difference between $40 million and the average
usage of the revolving credit facility, payable on a monthly basis. NATC is also
required to pay the Lenders letter of credit fees equal to 4.00% per annum
multiplied by the face of amount of the letters of credit issued under the
Financing Agreement, payable on the date any such letter of credit is issued. In
addition, NATC is required to pay the Agent the standard charges customarily
charged by the institution issuing letters of credit under the Financing
Agreement in connection with the issuance, administration, amendment, payment or
cancellation of any such letters of credit.
The Financing Agreement requires NATC to meet a maximum leverage ratio and a
test of minimum earnings before interest, taxes, depreciation, amortization,
certain cash and non-cash charges, other income and expenses and restructuring
charges ("EBITDAR"). The Financing Agreement also contains covenants which,
among other things, limit the incurrence of additional indebtedness,
distribution of dividends, transactions with affiliates, asset sales,
acquisitions, mergers, prepayments of other indebtedness, liens and
encumbrances, capital expenditures, and other matters customarily restricted in
such agreements. In addition, the Financing Agreement requires that the Chief
Executive Officer of NATC be reasonably acceptable to the Agent and the Lenders
during the term of the Credit Facility.
The Financing Agreement contains customary events of default, including payment
defaults, breach of representations and warranties, covenant defaults,
cross-acceleration, cross-defaults to certain other indebtedness, bankruptcy and
insolvency, the occurrence of a Change of Control, as defined in the Financing
Agreement, and judgment defaults. Further, it is an event of default under the
Financing Agreement if an event or development occurs that results in a Material
Adverse Effect (as defined in the Financing Agreement), as determined by the
Agent in its reasonable business judgment. If any events of default occur and
are not cured within applicable grace periods or waived, the outstanding loans
may be accelerated and the Lenders' commitments may be terminated. The
occurrence of the bankruptcy and insolvency event of default will result in the
automatic termination of commitments and acceleration of outstanding loans under
the Financing Agreement.
14
9. SENIOR REVOLVING CREDIT FACILITY
In connection with the February 2004 refinancing, NATC amended and restated its
prior Revolving Credit Facility, resulting in a $50.0 million Senior Revolving
Credit Facility with Bank One, N.A., as agent (the "Agent Bank"), and LaSalle
Bank, National Association. The Old Credit Agreement governing the old Senior
Revolving Credit Facility includes a letter of credit sublimit of $25.0 million
and was scheduled to mature three years from the closing date. NATC's intentions
were to use the Senior Revolving Credit Facility for working capital and general
corporate purposes. On January 19, 2005, the Old Credit Agreement was amended to
reduce the old Senior Revolving Credit Facility to $35.0 million. As of December
31, 2004, NATC had borrowed $14.5 million under the old Senior Revolving Credit
Facility.
Indebtedness under the Old Credit Agreement was guaranteed by each of NATC's
current and future direct and indirect subsidiaries, and secured by a first
perfected lien on substantially all of NATC's and its direct and indirect
subsidiaries' current and future assets and property. The collateral included a
pledge by the Company of its equity interest in NATC and a first priority lien
on all equity interests and intercompany notes held by NATC and each of its
subsidiaries.
Each advance under the Old Credit Agreement bore interest at variable rates
based, at NATC's option, on either the prime rate plus 1% or LIBOR plus 3%. As
of September 30, 2004, the interest rate on this financing was 4.8%.
Under the Old Credit Agreement, NATC was required to pay the lenders an annual
commitment fee in variable amounts ranging from 0.50% to 0.65% of the difference
between the commitment amount and the average usage of the facility, payable on
a quarterly basis. NATC was also required to pay to the lenders letter of credit
fees equal to 3.00% per annum multiplied by the maximum amount available from
time to time to be drawn under such letters of credit issued under the Old
Credit Agreement and to the lenders issuing letters of credit a fronting fee of
0.125% per annum multiplied by the aggregate face amount of letters of credit
outstanding during a fiscal quarter plus other customary administrative,
amendment, payment and negotiation charges in connection with such letters of
credit.
The Old Credit Agreement required NATC and its subsidiaries to meet certain
financial tests, including a minimum fixed charge coverage ratio and a minimum
consolidated adjusted earnings before interest, taxes, dividends and
amortization ("EBITDA"). The Old Credit Agreement also contained covenants
which, among other things, limited the incurrence of additional indebtedness,
dividends, transactions with affiliates, asset sales, acquisitions, mergers,
prepayments of other indebtedness, liens and encumbrances and other matters
customarily restricted in such agreements. In addition, the Old Credit Agreement
required that certain members of executive management remain active in the
day-to-day operation and management of NATC and its subsidiaries during the term
of the facility.
15
The Old Credit Agreement contained customary events of default, including
payment defaults, breach of representations and warranties, covenant defaults,
cross-acceleration, cross-defaults to certain other indebtedness, certain events
of bankruptcy and insolvency, the occurrence of a Change in Control and judgment
defaults.
On March 30, 2005, the Old Credit Agreement was amended to modify the fixed
charge coverage ratio covenant, which after modification applied only to
quarters ending June 30, 2005 and thereafter. The fixed charge coverage ratio
definition was also amended to include any future cash equity contributions to
the Company. In addition, the amendment changed the Old Credit Agreement
maturity date from February 28, 2007 to January 31, 2006.
See Note 8 of the Condensed Consolidated Financial Statements for discussion of
the June 16, 2005 Financing Agreement, the proceeds of which were used to
refinance and terminate the Old Credit Agreement.
10. PROVISION FOR INCOME TAXES
The Company has determined that at September 30, 2005, its ability to realize
future benefits of certain net deferred tax assets does not meet the "more
likely than not" criteria in SFAS No. 109, "Accounting for Income Taxes";
therefore, a valuation allowance continues to be recorded. Deferred income tax
liabilities are provided relating to inventories and tax-deductible goodwill
that is not amortized for financial reporting.
11. PENSION AND POSTRETIREMENT BENEFIT PLANS
The components of Net Periodic Benefit Cost for the nine months ended September
30 are as follows (in thousands):
Pension Benefits Other Benefits
-------------------------------- --------------------------------
2005 2004 2005 2004
--------------- ------------- --------------- -------------
Service cost $ 34 $ 221 $ 327 $ (2,481)
Interest cost 589 587 356 134
Expected return of plan assets (552) (711) - -
Amortization of net (gain) loss 85 91 101 204
--------------- ------------- --------------- -------------
Net periodic pension cost $ 156 $ 188 $ 784 $ (2,143)
=============== ============= =============== =============
NATC has a defined benefit pension plan covering substantially all of its hourly
employees. Benefits for the hourly employees' plan are based on a stated benefit
per year of service, reduced by amounts earned in a previous plan.
Effective June 30, 2004 and July 31, 2004, NATC froze the defined benefit
retirement plan for the respective hourly employees of its three collective
bargaining units. Based upon this above decision, management believes that any
future contributions will not be material.
16
Effective September 30, 2004, NATC terminated its postretirement benefit plan
for its salaried employees. Accordingly, NATC recognized a reduction in the
postretirement benefit plan liability of $3,811. The Company expects to
contribute approximately $500 to its postretirement plan in 2005 for the payment
of benefits. Plan contributions and benefits have amounted to $374 for the nine
months ended September 30, 2005.
12. RECONCILIATION OF INCOME (LOSS) PER COMMON SHARE
(DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS):
THREE MONTHS ENDED SEPTEMBER 30, 2005
-------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
---------------- ---------------- ----------------
Basic and Diluted:
Net loss (3,978)
----------------
Net income applicable to common shares $ (3,978) 589.3 $ (6.75)
================ ================ ================
THREE MONTHS ENDED SEPTEMBER 30, 2004
-------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
-------------- ----------------- ----------------
Basic:
Net income $ 5,932
----------------
Net income applicable to common shares $ 5,932 591.3 $ 10.03
================ ================= ================
Diluted:
Net income $ 5,932
----------------
Net income applicable to common shares $ 5,932 718.9 $ 8.25
================ ================= =================
NINE MONTHS ENDED SEPTEMBER 30, 2005
------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
---------------- ----------------- ---------------
Basic and Diluted:
Net loss (16,238)
---------------
Net income applicable to common shares $ (16,238) 589.3 $ (27.55)
=============== ================= =================
NINE MONTHS ENDED SEPTEMBER 30, 2004
------------------------------------
Income Shares Per Share
(Numerator) (Denominator) Amount
--------------- ----------------- ---------------
Basic and Diluted:
Net income $ 411
Less: preferred stock dividends (1,613)
---------------
Net income applicable to common shares $ (1,202) 573.2 $ (2.10)
=============== ================= ================
On February 9, 2004, in connection with the Merger, all the common shares of
NATC were cancelled and shares of the Company were issued to NATC's shareholders
on a one-for-one basis.
17
The earnings per share calculations are based on the weighted average number of
shares of common stock outstanding during the respective periods. Common stock
equivalent shares from warrants representing 63,490 shares were excluded from
the computations for the three months ended September 30, 2005 and the nine
months ended September 30, 2005 and 2004, respectively.
13. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the FASB issued SFAS No. 123R (Revised 2004), "Accounting for
Stock Based Compensation" ("SFAS No. 123R"). SFAS No. 123R establishes standards
for the accounting for transactions in which an entity exchanges its equity
instruments for goods or services. It also addresses transactions in which an
entity incurs liabilities in exchange for goods or services that are based on
the fair value of the entity's equity instruments or that may be settled by the
issuance of those equity instruments. SFAS No. 123R eliminates the alternative
to use APB 25's intrinsic value method of accounting that was provided in SFAS
No. 123 as originally issued. SFAS No. 123R requires entities to recognize the
cost of employee services received in exchange for awards of equity instruments
based on the grant-date fair value of those awards (with limited exceptions).
That cost will be recognized over the period during which an employee is
required to provide service in exchange for the award or the vesting period. No
compensation cost is recognized for equity instruments for which employees do
not render the requisite service. A public entity will initially measure the
cost of liability based service awards based on their current fair value; the
fair value of those awards will be remeasured subsequently at each reporting
date through the settlement date. Changes in fair value during the requisite
service period will be recognized as compensation cost over that period. The
provisions of SFAS No. 123R shall become effective for the Company in the first
quarter of 2006 and will apply to all awards granted after December 31, 2005 and
to awards modified, repurchased, or cancelled after that date. The Company is
evaluating SFAS No. 123R and believes it will not have a material effect on
financial results of operations.
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an amendment
of ARB No. 43, Chapter 4," to clarify the accounting for abnormal amounts of
idle facility expense, freight, handling costs, and wasted material (spoilage).
SFAS No. 151 requires that items be recognized as current-period charges
regardless of whether they meet the criterion of "so abnormal" that was
previously stated in ARB No. 43, Chapter 4. In addition, SFAS No. 151 requires
that allocation of fixed production overheads to the costs of conversion be
based on the normal capacity of the production facilities. The provisions of
this statement shall be effective for inventory costs incurred during fiscal
years beginning after June 15, 2005. The Company does not expect SFAS No. 151 to
have a material impact on the Company's financial condition or results of
operations.
In December 2004, the FASB issued two FASB Staff Positions ("FSP") regarding the
accounting implications of the American Jobs Creation Act of 2004 (the "Act").
The Act provides a deduction for income from qualified domestic production
activities, which will be phased in from 2005 through 2010. In return, the Act
also provides for a two-year phase-out of the existing extra-territorial income
exclusion ("ETI") for foreign sales. Under the guidance in FSP No. FAS 109-1,
"Application of FASB Statement 109, `Accounting for Income Taxes,' to the Tax
Deduction on Qualified Production Activities Provided by the American Jobs
Creation Act of 2004," the deduction will be treated as a "special deduction" as
18
described in FASB Statement No. 109. As such, the special deduction has no
effect on deferred tax assets and liabilities existing at the enactment date.
FSP No. FAS 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings
Repatriation Provision within the American Jobs Creation Act of 2004," was
effective for the first quarter of 2005 and had no material impact on the
Company's Condensed Consolidated Financial Statements.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error
Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3."
SFAS No. 154 requires retrospective application to prior periods' financial
statements for changes in accounting principle, unless it is impracticable to
determine either the period-specific effects or the cumulative effect of the
change. SFAS No. 154 also requires that retrospective application of a change in
accounting principle be limited to the direct effects of the change. Indirect
effects of a change in accounting principle, such as a change in
non-discretionary profit-sharing payments resulting from an accounting change,
should be recognized in the period of the accounting change. SFAS No. 154 is
effective for accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. The Company will comply with the provisions
of this statement for any accounting changes or error corrections that occur
after December 31, 2005.
14. CONTINGENCIES
LITIGATION WITH REPUBLIC TOBACCO
On July 15, 1998, North Atlantic Operating Company, Inc. ("NAOC") and National
Tobacco Company, L.P. ("NTC"), which are subsidiaries of the Company, filed a
complaint (the "Kentucky Complaint") against Republic Tobacco, Inc. and its
affiliates ("Republic Tobacco") in Federal District Court for the Western
District of Kentucky. Republic Tobacco imports and sells Roll-Your-Own ("RYO")
premium cigarette papers under the brand names JOB and TOP as well as other
brand names. The Kentucky Complaint alleges, inter alia, that Republic Tobacco's
use of exclusivity agreements, rebates, incentive programs, buy-backs and other
activities related to the sale of premium cigarette papers in the southeastern
United States violate federal and state antitrust and unfair competition laws
and that Republic Tobacco defaced and directed others to deface NAOC's point of
purchase vendor displays for premium cigarette papers by covering up the ZIG-ZAG
brand name and advertising material with advertisements for Republic Tobacco's
RYO cigarette paper brands. The Kentucky Complaint alleges that these activities
constitute unfair competition under federal and state laws.
On June 30, 1998, Republic Tobacco filed a complaint against NATC, NAOC and NTC
in the U.S. District Court of the Northern District of Illinois (the "Illinois
Complaint") and served it on NATC after the institution of the Kentucky action.
In the Illinois Complaint, Republic Tobacco seeks declaratory relief with
respect to NATC's claims. In addition, the Illinois Complaint alleges that
certain actions taken by NATC to inform its customers of its claims against
Republic Tobacco constitute tortious interference with customer relationships,
false advertising, violations of Uniform Deceptive Trade Practices and Consumer
Fraud Acts, defamation and unfair competition. In addition, although not
included in its original complaint but in its amended complaint, Republic
Tobacco alleged that NATC has unlawfully monopolized and attempted to monopolize
the market on a national and regional basis for premium cigarette papers.
Republic sought unspecified compensatory damages, injunctive relief and
attorneys fees and costs.
19
On October 20, 2000, Republic Tobacco filed a motion to dismiss, stay, or
transfer the Kentucky Complaint to the Illinois Court. On December 19, 2000, the
Court denied Republic Tobacco's motion, holding that it was premature. The Court
noted also that it had communicated with the Court in Illinois and that it had
concluded that Republic Tobacco may not be entitled to any preference on forum
selection, which would ordinarily be given because it was first to file. The
Kentucky complaint is still on file.
Prior to the completion of discovery, the Court dismissed Republic Tobacco's
antitrust claims against NATC. After discovery was completed in 2001, both
parties moved for summary judgment on the others claims. In April 2002, the
District Court for the Northern District of Illinois decided the summary
judgment motions by dismissing all claims of both NATC and Republic Tobacco and
its affiliates, except for Republic Tobacco's claim of defamation per se against
NATC, on which it granted summary judgment on liability in favor of Republic
Tobacco, and a Lanham Act false advertising claim, based on the same facts as
the defamation claim, for equitable relief. In February 2003, the District Court
granted Republic's motion for summary judgment on NATC's counterclaim that
Republic tortiously interfered with NATC's business relationships and economic
advantage. The only claim that remained to be tried was Republic's Lanham Act
claim and damages on the defamation claim on which the Court previously ruled
that Republic could only obtain equitable relief if successful.
On July 8, 2003, following a four-day trial, an Illinois jury returned a verdict
in favor of Republic on the defamation claims of $8.4 million in general damages
and $10.2 million in punitive damages, for a total damage award of $18.6
million. NATC recorded an $18.8 million charge during the second quarter 2003
relating to this transaction. NATC filed post-trial motions for a new trial and,
in the alternative, for a reduction of the awards. On August 1, 2003, NATC
posted a judgment bond in the amount of $18.8 million with the U.S. District
Court. This was accomplished by obtaining a $19.0 million senior secured term
loan pursuant to a July 31, 2003 amendment to NATC's existing credit facility.
On November 20, 2003, the court ruled that the awards were excessive and reduced
the awards by approximately 60%, with the award of compensatory damages being
reduced to $3.36 million and the award of punitive damages being reduced to
$4.08 million, for a total of $7.44 million. On December 18, 2003, Republic
accepted these reduced awards. NATC reversed $11.16 million during the fourth
quarter 2003 due to this court ruling.
On January 8, 2004, NATC appealed the final judgment, including the finding of
liability in this case as well as the amount of the award. On January 22, 2004,
Republic filed a general notice of cross appeal and argued in its appellate
briefs that the judgment should be affirmed and also asserted, in its
cross-appeal, that the original judgment should be reinstated despite its
acceptance of the District Court's order reducing the judgment amount.
On September 1, 2004, the Court of Appeals issued its ruling affirming the
finding of liability against NATC for defamation, but reducing the amount of the
damage award to $3.0 million. The Court of Appeals also affirmed the dismissal
of NATC's antitrust claim against Republic and the dismissal of Republic's
motion to re-instate the original jury award of $18.8 million. As a result of
these rulings, in October 2004 NATC received approximately $4.5 million relating
to the cash bond it had posted with the Court in 2003. This amount was included
in Other income during the third quarter of 2004.
20
NATC also applied to the Court of Appeals for an order awarding NATC
approximately $1.0 million for the difference in the expense of the original
bond of $18.8 million and the subsequent reduced bond of $7.0 million and the
lesser expense NATC would have incurred to bond the final $3.0 million judgment.
On November 30, 2004, the Court of Appeals ruled that the application for costs
should be directed to the District Court. On December 17, 2004, NATC filed this
motion with the District Court.
On August 3, 2005, the District Court issued its ruling and awarded NATC
approximately $1.1 million. This amount is not included in the condensed
consolidated financial statements. On August 11, 2005, Republic Tobacco filed a
notice of appeal. No briefing schedule has been established.
LITIGATION RELATED TO COUNTERFEITING
Texas Infringing Products Litigation. In Bollore, S.A. v. Import Warehouse,
Inc., Civ. No. 3-99-CV-1196-R (N.D. Texas), Bollore, the Company's Licensor of
ZIG-ZAG brand premium cigarette papers, obtained a sealed order allowing it to
conduct a seizure of infringing and counterfeit ZIG-ZAG products in the United
States. On June 7, 1999, seizures of products occurred in Michigan and Texas.
Subsequently, all named defendants have been enjoined from buying and selling
such infringing or counterfeit goods. Bollore and NATC negotiated settlements
with all defendants. These defendants included Import Warehouse, Ravi Bhatia,
Tarek Makki and Adham Makki. Those settlements included a consent injunction
against distribution of infringing or counterfeit goods.
On May 18, 2001, NATC, in conjunction with Bollore and law enforcement
authorities conducted raids on the businesses and homes of certain defendants
previously enjoined (including Tarek Makki and Adham Makki) from selling
infringing or counterfeit ZIG-ZAG brand products in the Bollore S.A. v. Import
Warehouse litigation. Evidence was uncovered that showed that these defendants
and certain other individuals were key participants in importing and
distributing counterfeit ZIG-ZAG premium cigarette papers. After a two day
hearing in the U.S. District Court for the Northern District of Texas, on May
30, 2001, the Court held the previously enjoined defendants in contempt of
court, and enjoined the additional new defendants, including Ali Makki, from
selling infringing or counterfeit ZIG-ZAG premium cigarette papers.
NATC entered into a settlement with the defendants, the principal terms of which
included a cash payment, an agreed permanent injunction, the withdrawal of the
defendants' appeal of the civil contempt order, an agreed judgment of $11.0
million from the civil contempt order and an agreement to forbear from enforcing
that $11.0 million money judgment until such time in the future that the
defendants violate the terms of the permanent injunction. Two of the defendants,
Tarek Makki and Adham Makki, also agreed to provide complete information
concerning the counterfeiting conspiracy as well as information on other parties
engaged in the purchase and distribution of infringing ZIG-ZAG premium cigarette
papers.
On February 17, 2004, NATC and Bollore filed a motion in the U.S. District Court
for the Northern District of Texas, which had issued the original injunctions
against the infringing defendants, seeking, with respect to respondents Adham
Makki, Tarek Makki and Ali Makki, to have the $11.0 million judgment released
from the forbearance agreement and to have the named respondents held in
contempt of court. The motion alleged that the three respondents had trafficked
in counterfeit ZIG-ZAG cigarette papers after the execution of the settlement,
citing evidence that all three had been charged in the United States District
Court for the Eastern District of Michigan with criminal violations of the
United States counterfeiting laws by trafficking in counterfeit ZIG-ZAG
cigarette papers, which trafficking occurred after the settlement agreement.
21
On April 13, 2004, the Court entered an order (the "Contempt 2 Order"), finding
Ali Mackie, Tarek Makki, Adham Mackie and their companies Best Price Wholesale
(the "Makki Defendants") and Harmony Brands LLC in civil contempt, freezing all
of their assets, releasing the July 12, 2002 Final Judgment of $11.0 million
from the forbearance agreement as to the Makki Defendants, and again referring
the matter to the United States Attorney for Criminal Prosecution. Subsequent to
the entry of the Contempt 2 Order, the Company settled with defendant Harmony
Brands and its members for the amount of $750,000 and the entry of a permanent
injunction. The Company is seeking to execute on the outstanding $11.0 million
judgment against the remaining Makki Defendants and those efforts are currently
underway.
Pursuant to the U.S. Distribution Agreement and a related agreement between
Bollore and NATC, any collections on the judgments issued in the Bollore v.
Import Warehouse case are to be divided evenly between Bollore and NATC after
the payment of all expenses.
On February 7, 2002, Bollore, NAOC and NATC filed a motion with the District
Court in the Texas action seeking to hold Ravi Bhatia and Import Warehouse Inc.
in contempt of court for violating the terms of the consent order and injunction
entered against those defendants. NATC alleges that Mr. Bhatia and Import
Warehouse sold counterfeit goods to at least three different companies over an
extended period of time. On June 27, 2003, the Court found Import Warehouse and
Mr. Bhatia in contempt of court for violating an existing injunction barring
those parties from distributing infringing ZIG-ZAG cigarette paper products. The
Court requested that NATC and Bollore (NATC's co-plaintiff in the case) file a
submission detailing the damages incurred. NATC and Bollore filed their
submission on July 25, 2003 which reported and requested damages of $2.4
million.
On July 1, 2004, the Court issued an Order awarding approximately $2.5 million
in damages to NATC for the damages incurred by NATC as a result of the Import
Warehouse Defendants' civil contempt. On July 15, 2004, the Court entered a
Final Judgment in that amount for which defendants Import Warehouse, Inc. and
Ravi Bhatia are jointly and severally liable. After NATC and Bollore commenced
collection proceedings, Import Warehouse paid NATC and Bollore an amount equal
to the entire judgment plus the expenses incurred in collection. Accordingly,
approximately $1.2 million has been recorded in Other income during the third
quarter of 2004. The Import Warehouse Defendants filed a notice of appeal on
July 24, 2004. No briefing schedule has been established.
On September 23, 2005, in Bollore S.A. v. Beydoun, CV05-1679 S, NATC and Bollore
filed a complaint in the United States District Court for the Western District
of Louisiana against certain individuals and companies alleging that they had
engaged in a conspiracy to manufacture and distribute counterfeit Zig-Zag
cigarette papers in the United States. The complaint sought, among other things,
an injunction and damages. The civil case follows the conviction on federal
criminal counterfeiting charges of one of the alleged participants in the
conspiracy.
LITIGATION RELATED TO ALLEGED PERSONAL INJURY
West Virginia Complaints. Trial of the West Virginia complaints against the
smokeless tobacco defendants has been postponed indefinitely, as described
below. On October 6, 1998 NTC was served with a summons and complaint on behalf
of 65 individual plaintiffs in an action in the Circuit Court of Kanawha County,
West Virginia, entitled Kelly Allen, et al. v. Philip Morris Incorporated, et
al. (Civil Action Nos. 98-C-240l). On November 13, 1998, NTC was served with a
second summons and complaint on behalf of 18 plaintiffs in an action in the
22
Circuit Court of Kanawha County, West Virginia, entitled Billie J. Akers, et al.
v. Philip Morris Incorporated et al. (Civil Action Nos. 98-C-2696 to 98-C-2713).
The complaints are identical in most material respects. In the Allen case, the
plaintiffs have specified the defendant companies for each of the 65 cases. NTC
is named in only one action. One Akers plaintiff alleged use of an NTC product,
alleging lung cancer.
On September 14, 2000, NTC was served with a summons and complaint on behalf of
539 separate plaintiffs filed in Circuit Court of Ohio County, West Virginia,
entitled Linda Adams, et al. v. Philip Morris Inc., et al. (Civil Action Nos.
00-C-373 to 00-C-911). Only one of these plaintiffs alleged use of a product
currently manufactured by NTC. The time period during which this plaintiff
allegedly used the product has not yet been specified. Thus, it is not yet known
whether NTC is a proper defendant in this case.
On September 19, 2000, NTC was served with a second summons and complaint on
behalf of 561 separate plaintiffs filed in Circuit Court of Ohio County, West
Virginia, entitled Ronald Accord, et al. v. Philip Morris Inc., et al. (Civil
Action Nos. 00-C-923 to 00-C-1483). A total of five of these plaintiffs alleged
use of a product currently manufactured by NTC. One of these plaintiffs does not
specify the time period during which the product was allegedly used. Another
alleges use that covers, in part, a period when NTC did not manufacture the
product. On motion by cigarette company defendants, this claim was dismissed on
February 11, 2004, for failure to follow the case management order. Of the
remaining three, one alleges consumption of a competitor's chewing tobacco from
1966 to 2000 and NTC's Beech-Nut chewing tobacco from 1998 to 2000; another
alleges a twenty-four year smoking history ending in 1995 and consumption of
Beech-Nut chewing tobacco from 1990 to 1995; and the last alleges a thirty-five
year smoking history ending in 2000, and consumption of NTC's Durango Ice
chewing tobacco from 1990 to 2000 (although Durango Ice did not come onto the
market until 1999).
In November 2001, NTC was served with an additional four separate summons and
complaints in actions filed in the Circuit Court of Ohio County, West Virginia.
The actions are entitled Donald Nice v. Philip Morris Incorporated, et al.
(Civil Action No. 01-C-479), Korene S. Lantz v. Philip Morris Incorporated, et
al. (Civil Action No. 01-C-480), Ralph A. Prochaska, et al. v. Philip Morris,
Inc., et al. (Civil Action No. 01-C-481), and Franklin Scott, et al. v. Philip
Morris, Inc., et al., (Civil Action No. 01-C-482).
All of the West Virginia smokeless tobacco actions have been consolidated before
the West Virginia Mass Litigation Panel for discovery and trial of certain
issues. Trial of these matters was planned in two phases. In the initial phase,
a trial was to be held to determine whether tobacco products, including all
forms of smokeless tobacco, cigarettes, cigars and pipe and roll-your-own
tobacco, can cause certain specified diseases or conditions. In the second
phase, individual plaintiffs would attempt to prove that they were in fact
injured by tobacco products. Fact and expert discovery in these cases has
closed, however, in the cigarette cases the Court has allowed additional
discovery.
The claims against NTC in the various consolidated West Virginia actions include
negligence, strict liability, fraud in differing forms, conspiracy, breach of
warranty and violations of the West Virginia consumer protection and antitrust
acts. The complaints in the West Virginia cases request unspecified compensatory
and punitive damages.
The manufacturers of smokeless tobacco products (as well as the manufacturers of
cigarettes) moved to sever the claims against the smokeless tobacco manufacturer
defendants from the claims against the cigarette manufacturer defendants. That
motion was granted and the trial date on the smokeless tobacco claims has now
been postponed indefinitely.
23
The trial court has now vacated the initial trial plan in its entirety because
of concerns that its provisions violated the dictates of the United States
Supreme Court's decision in State Farm Mutual Automobile Insurance Company v.
Campbell, 538 U.S. 408 (2003). A new trial plan has not yet been implemented
with regard to the consolidated claims against the cigarette manufacturer
defendants. The West Virginia Supreme Court has accepted review of the case
management order and briefing by the parties was commenced. The claims against
the smokeless tobacco manufacturer defendants remain severed and indefinitely
stayed.
Minnesota Complaint. On September 24, 1999, NTC was served with a complaint in a
case entitled Tuttle v. Lorillard Tobacco Company, et al. (Case No. C2-99-7105),
brought in Minnesota. The other manufacturing defendants are Lorillard and The
Pinkerton Tobacco Company. The Complaint alleges that plaintiff's decedent was
injured as a result of using NTC's (and, prior to the formation of NTC,
Lorillard's) Beech-Nut brand and Pinkerton's Red Man brand of loose-leaf chewing
tobacco. Plaintiff asserts theories of liability, breach of warranty, fraud, and
variations on fraud and misrepresentation. Plaintiff specifically requests in
its complaint an amount of damages in excess of fifty thousand dollars ($50,000)
along with costs, disbursements and attorneys' fees, and ". . . an order
prohibiting defendants from disseminating in Minnesota further misleading
advertising and making further untrue, deceptive and/misleading statements about
the health effects and/or addictive nature of smokeless tobacco products. . . ."
After discovery, summary judgment motions were filed on behalf of all
defendants. On March 3, 2003, the Court granted defendants' motions, dismissing
all claims against all defendants and the Court has since denied the plaintiff's
motion for reconsideration. Plaintiff has appealed the dismissal. Briefing has
been completed. Oral argument before the Court of Appeals was held on February
11, 2004. On July 30, 2004, the Court of Appeals affirmed the dismissal of all
of the claims.
In addition to the above described legal proceedings, the Company is subject to
other litigation in the ordinary course of its business. The Company does not
believe that any of these other proceedings will have a material adverse effect
on the results of operations, financial position or cash flows of the Company.
OTHER EMPLOYMENT MATTERS
The Company may, from time to time, have claims from and make settlements with
former officers or employees.
David I. Brunson, the former President, Chief Financial Officer and Treasurer of
the Company, resigned from the Company effective January 19, 2005, at which time
his employment agreement with the Company (the "Brunson Employment Agreement")
was effectively terminated. Pursuant to the Brunson Employment Agreement, the
Company is required to make certain severance payments to Mr. Brunson, including
$425,000, which was paid within ten business days after January 19, 2005, and an
additional $425,000 payable within the next 12 months. In addition, Mr. Brunson
may become entitled to a bonus payment of up to $725,000 relating to synergies
achieved in the integration of the business of Stoker, Inc. that was acquired by
the Company in 2003. Pursuant to the Brunson Employment Agreement, after the
last severance payment is made, Mr. Brunson will have an option to require the
Company to repurchase all or a portion of his shares of Parent at their fair
market value. The Company will not be obligated to repurchase these shares if,
24
upon or after the payment, it would be in default under any instrument,
agreement or law by which it is bound; in this case, the repurchase may be
deferred until it can be completed without such default. Similarly, the Company
has an option to repurchase Mr. Brunson's shares at their fair market value. In
the event the Company and Mr. Brunson are unable to agree upon the fair market
value of these shares, an independent investment banking firm will be selected
to determine such fair market value, in accordance with the procedure provided
for by the Brunson Employment Agreement. If neither Mr. Brunson nor the Company
exercise their respective options by the earliest of the fifth anniversary of
the termination of Mr. Brunson's employment or the date on which the Company
refinances, or uses proceeds derived from refinancing, certain of its
obligations, the Company will be required to repurchase Mr. Brunson's shares on
such date unless Mr. Brunson waives his right to require the Company to purchase
his shares. Any liability is deemed, at this time, not to be material to the
Company's Condensed Consolidated Financial Statements. No amounts have been
accrued related to potential amounts payable to Mr. Brunson associated with the
Stoker restructuring bonus or the requirement to repurchase his stock.
During the nine months ended September 30, 2005, the Company recorded
approximately $1.1 million relating to the resignation of Mr. Brunson. Any
options or shares of restricted stock granted to Mr. Brunson vested in full as
of the date of such resignation.
A&M is entitled to a fee based on improvement in the Company's financial
performance as measured against the Company's 2005 Business Plan, to be paid
upon the termination of the engagement. One portion of the fee will be a
specified percentage of the sustainable annualized EBITDAR improvement, as
defined, and the other portion of the fee will be an amount to be determined by
the Board of Directors of the Company in their reasonable judgment for
significant and sustainable improvement in working capital investment and
management, in each case as measured against the Company's 2005 Business Plan.
As of September 30, 2005, no related liability or expense has been recorded
relating to financial performance improvements.
15. SEGMENT INFORMATION
In accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise
and Related Information," the Company has three reportable segments. The
smokeless tobacco segment manufactures smokeless tobacco products which are
distributed primarily through wholesale and food distributors in the United
States. The make-your-own segment imports and distributes premium cigarette
papers and contract manufactures and distributes cigarette tobaccos and related
products primarily through wholesale distributors in the United States. The
premium cigarette segment distributes contract manufactured cigarettes through
wholesale distributors in the United States.
The accounting policies of these segments are the same as those of the Company.
Segment data includes a charge allocating corporate costs to the Smokeless
Tobacco and Make-Your-Own segments based on their respective Net sales. Other
includes the assets of the Company not assigned to segments and Eliminations
includes the elimination of intercompany accounts between segments. The Company
evaluates the performance of its segments and allocates resources to them based
on Operating income.
25
RECLASSIFICATIONS: Certain prior year amounts have been reclassified to conform
to the current year presentation. These changes had no impact on previously
reported net income.
FOR THE MAKE PREMIUM
THREE MONTHS ENDED: SMOKELESS YOUR MANUFACTURED
SEPTEMBER 30, 2005 TOBACCO OWN CIGARETTES OTHER ELIMINATIONS TOTAL
------------------------- -------------- ------------ ----------------- ---------- --------------- -------------
Net sales $ 11,364 $ 16,233 $ 54 $ 1,196 $ - $ 28,847
Operating income 2,377 3,833 (1,184) 200 - 5,226
Assets 76,705 286,428 4,482 22,076 (156,181) 233,510
September 30, 2004
-------------------------
Net sales $ 11,379 $ 18,059 $ 42 $ 1,261 $ - $ 30,741
Operating income 4,220 7,923 (1,118) 275 - 11,300
Assets 71,514 285,572 4,100 23,247 (111,594) 272,839
FOR THE MAKE PREMIUM
NINE MONTHS ENDED: SMOKELESS YOUR MANUFACTURED
SEPTEMBER 30, 2005 TOBACCO OWN CIGARETTES OTHER ELIMINATIONS TOTAL
------------------------- -------------- ------------ ----------------- ---------- --------------- -------------
Net sales $ 32,907 $ 49,770 $ 385 $ 3,654 $ - $ 86,716
Operating income 2,636 10,128 (3,342) 515 - 9,937
Assets 76,705 286,428 4,482 22,076 (156,181) 233,510
SEPTEMBER 30, 2004
-------------------------
Net sales $ 35,341 $ 50,764 $ 165 $ 3,783 $ - $ 90,053
Operating income 10,259 13,207 (3,624) 85 - 19,927
Assets 71,514 285,572 4,100 23,247 (111,594) 272,839
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The Company competes in three distinct markets: (1) the smokeless tobacco
market; (2) the Make-Your-Own ("MYO") cigarette market; and (3) the premium
manufactured cigarette market. The smokeless tobacco market includes the loose
leaf chewing tobacco sector. The MYO cigarette market is comprised of the MYO
premium cigarette papers sector and the MYO cigarette tobaccos and related
products sector. The Company's subsidiaries manufacture and market loose leaf
chewing tobacco, import and distribute MYO premium cigarette papers, contract
manufacture and market MYO cigarette tobaccos and related products, and contract
manufacture and market premium manufactured cigarettes. To date, the Company's
premium manufactured cigarette segment continues in its development phase and
net sales of this segment have not been significant.
26
RESULTS OF OPERATIONS
COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004
Net Sales. Net sales for the three months ended September 30, 2005 were $28.8
million, a decrease of $1.9 million or 6.2% from the corresponding period of the
prior year.
Net sales of the smokeless tobacco segment for the three months ended September
30, 2005 were $11.4 million which were flat compared to the corresponding period
of the prior year. Despite a price increase in the Company's premium brands,
overall net sales reflected no increase due to a continuing decline in the
segment coupled with a product mix shift from premium to value brands.
Net sales of the Company's MYO segment decreased $1.8 million or 10.1% in
comparison to the corresponding period of the prior year. Within the MYO
segment, premium cigarette paper sales decreased $3.4 million or 26.5% from the
corresponding period of the prior year due to the Company's continuing efforts
to reduce trade inventories. The MYO cigarette tobaccos and related product
sales increased $1.6 million or 29.2% in comparison to the corresponding period
of the prior year due in part to a price increase instituted during June 2005.
Gross Profit. Gross profit for the three months ended September 30, 2005 totaled
$14.6 million, a decrease of $2.3 million or 13.7% from the corresponding period
of the prior year.
Gross profit of the smokeless tobacco segment increased $0.3 million or 5.4%
from the corresponding period of the prior year. Gross margin for this segment
increased to 52.8% of net sales for the current period from 50.0% in the
corresponding period of the prior year due to a price increase instituted during
June 2005.
Gross profit of the MYO segment for the current period decreased $2.5 million or
23.1% in comparison to the corresponding period of the prior year. The gross
margin of the MYO segment decreased to 50.2% of net sales for the current period
in comparison to 58.7% for the corresponding period of the prior year. This
decrease in gross margin was due principally to a product mix shift from premium
cigarette papers to MYO cigarette tobaccos and related products. Further, gross
profit decreased as a result of continuing efforts to reduce trade inventories.
Selling, General, and Administrative Expenses. Selling, general, and
administrative expenses for the three months ended September 30, 2005 were $8.6
million, an increase of $2.9 million or 51.1% in comparison to the corresponding
period of the prior year. Of this increase, $2.9 million resulted from income
recognized in the third quarter of 2004 due to the termination of the salaried
employee postretirement benefit. In addition, there was an increase in 2005 of
$0.7 million relating to compensation expense, offset by decreased travel of
$0.5 million and other expenses of $0.2 million.
Interest Expense and Amortization of Financing Costs. Interest expense and
amortization of financing costs increased $0.5 million or 6.8% to $7.8 million
for the three months ended September 30, 2005 as compared to the corresponding
period of the prior year. This increase was primarily due to interest expense
related to the $30.0 million term loan entered into on June 16, 2005.
27
Other Expense (Income). Other expense was $0.9 million for the three months
ended September 30, 2005 as compared to other income of $5.6 million during the
corresponding period of the prior year. Other expense of $0.9 million relates
principally to the write-off of equipment no longer used in the manufacturing
operations of the business. Other income of $5.6 million relates principally to
non-recurring legal related recoveries received during the third quarter of
2004.
Restructuring Charges. For the three months ended September 30, 2005, total
restructuring charges amounted to approximately $0.9 million, including, but not
limited to, severance and separation expenses, A&M fees and other non-recurring
expenses. The Company anticipates incurring additional expenses relating to the
restructuring during 2005 and 2006.
Income Tax Benefit (Expense). The Company has determined that at December 31,
2004, its ability to realize future benefits of net deferred tax assets does not
meet the "more likely than not" criteria in SFAS No. 109, "Accounting for Income
Taxes". Therefore, only deferred tax expense related to inventories and
tax-deductible goodwill is being recorded in 2005. Tax expense of $0.6 million
was recorded for the nine months ended September 30, 2005 relating to
amortization of deferred taxes on inventories and tax-deductible goodwill, and
state income taxes, compared to an expense of $4.4 million for the corresponding
period of the prior year. As of September 30, 2005, a valuation allowance
continues to be recorded. The effective income tax rate for the three months
ended September 30, 2004 was 38.0%.
Net Income (Loss). Due to the factors described above, net loss for the three
months ended September 30, 2005 was $4.0 million compared to net income of $5.9
million for the corresponding period of the prior year.
COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004
Net Sales. Net sales for the nine months ended September 30, 2005 were $86.7
million, a decrease of $3.3 million or 3.7% from the corresponding period of the
prior year.
Net sales of the smokeless tobacco segment for the current period decreased $2.4
million or 6.9% from the corresponding period of the prior year. Despite a price
increase in the Company's premium brands instituted during June 2005, overall
net sales decreased due to a continuing decline in the segment coupled with a
product mix shift from premium to value brands.
Net sales of the Company's MYO segment decreased $1.0 million or 2.0% in
comparison to the corresponding period of the prior year. Within the MYO
segment, premium cigarette paper sales decreased $3.2 million or 9.4% from the
corresponding period of the prior year due to the Company's continuing efforts
to reduce trade inventories. The MYO cigarette tobaccos and related product
sales increased $2.2 million or 13.4% in comparison to the corresponding period
of the prior year due in part to a price increase instituted during June 2005.
Gross Profit. Gross profit for the nine months ended September 30, 2005 totaled
$44.3 million, a decrease of $2.7 million or 5.8% from the corresponding period
of the prior year.
28
Gross profit of the smokeless tobacco segment decreased $1.4 million or 8.0%
from the corresponding period of the prior year. Gross margin for this segment
decreased to 48.4% of net sales for the current period from 49.0% in the
corresponding period of the prior year due to several factors, including
increased manufacturing costs per case coupled with an increase in case sales of
lower margin products.
Gross profit of the MYO segment for the current period decreased $1.9 million or
6.7% in comparison to the corresponding period of the prior year. The gross
margin of the MYO segment decreased to 52.6% of net sales for the current period
in comparison to 55.3% for the corresponding period of the prior year. This
decrease in gross margin was due principally to a product mix shift from premium
cigarette papers to MYO cigarette tobaccos and related products. Further, gross
profit decreased as a result of continuing efforts to reduce trade inventories.
Selling, General, and Administrative Expenses. Selling, general, and
administrative expenses for the nine months ended September 30, 2005 were $29.4
million, an increase of $2.4 million or 8.7% in comparison to the corresponding
period of the prior year. Of this increase, $2.9 million resulted from income
recognized in the third quarter of 2004 due to the termination of the salaried
employee postretirement benefit. In addition, there was an increase in 2005 of
$1.7 million relating to compensation expense, offset by $2.1 million employee
incentive payments made in February 2004 and other expense of $0.1 million.
Interest Expense and Amortization of Financing Costs. Interest expense and
amortization of financing costs decreased $1.2 million or 4.7% to $23.1 million
for the nine months ended September 30, 2005 as compared to the corresponding
period of the prior year. This decrease related principally to the write off of
old deferred financing costs of approximately $1.6 million during the first nine
months of 2004, relating to the recapitalization and reorganization consummated
in 2004, partially offset by the write off of deferred financing costs of
approximately $0.4 million relating to the Senior Revolving Credit Facility
which was refinanced during June 2005.
Other Income (Expense). Other expense was $2.5 million for the nine months ended
September 30, 2005 as compared to other income of $5.0 million during the
corresponding period of the prior year. Other expense of $2.5 million relates
primarily to the write-off of equipment no longer used in the manufacturing
operations of the business and expenses incurred relating to counterfeiting
during 2005. Other income of $5.0 million relates principally to non-recurring
legal related recoveries received during the third quarter of 2004.
Restructuring Charges. For the nine months ended September 30, 2005, total
restructuring charges amounted to approximately $4.9 million, including, but not
limited to, severance and separation expenses, A&M fees and other non-recurring
expenses. The Company anticipates incurring additional expenses relating to the
restructuring during 2005 and 2006.
Income Tax Benefit (Expense). The Company has determined that at December 31,
2004, its ability to realize future benefits of net deferred tax assets does not
meet the "more likely than not" criteria in SFAS No. 109, "Accounting for Income
Taxes". Therefore, only deferred tax expense related to inventories and
tax-deductible goodwill is being recorded in 2005. Tax expense of $0.6 million
was recorded for the nine months ended September 30, 2005 relating to
amortization of deferred taxes on inventories and tax-deductible goodwill, and
state income taxes, compared to an expense of $2.2 million for the corresponding
period of the prior year. As of September 30, 2005, a valuation allowance
continues to be recorded. The effective income tax rate for the nine months
ended September 30, 2004 was 38.0%.
Net Loss. Due to the factors described above, net loss for the nine months ended
September 30, 2005 was $16.2 million compared to net income of $0.4 million for
the corresponding period of the prior year.
29
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 2005, working capital was $31.8 million compared to $16.8
million at December 31, 2004, as restated. This increase was the result of a
decrease in the revolving credit facility of $14.5 million, a higher cash
balance of $2.2 million, a decrease in accounts payable of $1.8 million, a
decrease in accrued liabilities of $2.5 million, and a decrease in deferred
taxes of $0.7 million offset by decreased inventory of $4.5 million, a decrease
in accounts receivable of $0.4 million and decreased other current assets of
$1.8 million.
For the nine months ended September 30, 2005, net cash used in operating
activities was $6.8 million compared with $10.9 million in the corresponding
period of the prior year. This change was due primarily to reductions in
inventory and Other current assets, offset by the net loss.
For the nine months ended September 30, 2005, net cash used in investing
activities was $4.7 (including $1.2 million relating to deposits recorded in
Other current assets in 2004) million compared with $1.3 million in the
corresponding period of the prior year. This change was due to an increase in
capital expenditures. The Company believes that its net additions to property,
plant and equipment relating to the Stoker integration, purchasing of certain
manufacturing equipment and the continuing investment in data and related
systems for 2005 will be approximately $5.0 million.
For the nine months ended September 30, 2005, net cash provided by financing
activities was $13.7 million compared with $21.2 million in the corresponding
period of the prior year. This change was due primarily to the February 2004
refinancing and the June 2005 refinancing under the Financing Agreement.
The Company expects to be able to fund its seasonal working capital requirements
through its operating cash flows and, if needed, borrowings under the Financing
Agreement. As of September 30, 2005, the Company had not borrowed pursuant to
its $55.0 million revolver under the Financing Agreement.
On June 16, 2005, NATC refinanced its Old Credit Agreement by entering into the
Financing Agreement. See Note 8 to the Condensed Consolidated Financial
Statements included herein for a description of the Financing Agreement, which
description is incorporated herein by reference. The Financing Agreement
consists of a $30.0 million term loan facility and a $55.0 million revolving
credit facility, and includes a letter of credit sublimit of $10.0 million
(collectively, the "Credit Facility"). As of September 30, 2005, NATC had not
borrowed any monies under the revolving credit facility. The Credit Facility
will mature on June 30, 2010, and does not provide for any amortization of the
term loan prior to maturity. NATC will use the revolving credit facility for
working capital requirements and other general corporate purposes, including the
purchase of Company Notes.
30
On October 6, 2005, NATC purchased Company Notes with an accreted book value of
approximately $22.1 million (face value at maturity of approximately $29.5
million) for approximately $6.3 million in cash. The Company or NATC may, from
time to time, continue to acquire and/or retire all or a portion of the Company
Notes and/or New Senior Notes through cash purchases and/or exchanges for other
securities in open market purchases, privately negotiated transactions or
otherwise.
The Company is dependent on NATC's cash flows to service its debt. The amount of
cash interest to be paid by the Company to third parties during the next five
years is as follows: $0 in each of 2005, 2006, 2007 and March 1, 2008; $4,137
payable on September 1, 2008 and $4,137 payable on each of March 1 and September
1 thereafter, until maturity.
CONTRACTUAL OBLIGATIONS
-----------------------
Certain contractual obligations are summarized in our Annual Report on Form
10-K, as amended, for the year ended December 31, 2004 under the heading
"Contractual Obligations" in "Management's Discussion and Analysis of Financial
Condition and Results of Operations." As of September 30, 2005, with the
exceptions of the term loan under the Financing Agreement and the payoff of the
Senior Revolving Credit Facility in connection with the June 2005 refinancing
(see Note 8 to the Condensed Consolidated Financial Statements contained herein)
and the forward contracts entered into as more fully described in Item 3,
Quantitative and Qualitative Disclosures about Market Risk, there have been no
material changes outside the ordinary course of our business in such contractual
obligations from December 31, 2004.
FORWARD-LOOKING STATEMENTS
The Company cautions the reader that certain statements in the Management's
Discussion and Analysis of Financial Condition and Results of Operations section
as well as elsewhere in this Form 10-Q are "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are not guarantees of future performance. They
involve risks, uncertainties and other important factors, including the risks
discussed below. The Company's actual future results, performance or achievement
of results may differ materially from any such results, performance or
achievement implied by these statements. Among the factors that could affect the
Company's actual results and could cause results to differ from those
anticipated in the forward-looking statements contained herein is the Company's
ability to comply with certain Financing Agreement financial covenants, its
ability to implement its business strategy successfully, which may be dependent
on business, financial, and other factors beyond the Company's control,
including, among others, federal, state and/or local regulations and taxes,
competitive pressures, prevailing changes in consumer preferences, consumer
acceptance of new product introductions and other marketing initiatives, market
acceptance of the Company's current distribution programs, access to sufficient
quantities of raw material or inventory to meet any sudden increase in demand,
disruption to historical wholesale ordering patterns, product liability
litigation and any disruption in access to capital necessary to achieve the
Company's business strategy.
31
The Company cautions the reader not to put undue reliance on any forward-looking
statements. In addition, the Company does not have any intention or obligation
to update the forward-looking statements in this document. The Company claims
the protection of the safe harbor for forward-looking statements contained in
Section 21E of the Securities Exchange Act of 1934.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Except as described below, there have not been any significant changes with
respect to quantitative and qualitative disclosures about market risk from what
was previously disclosed in the Company's Annual Report on Form 10-K, as
amended, for the year ended December 31, 2004.
The Company purchases inventory from Bollore, payable in Euros, on terms of net
45 days. Accordingly, exposure exists to potentially adverse movement in foreign
currency rates (Euros). In addition, Bollore provides contractual relief against
significant currency fluctuations in its agreement with the Company. While the
Company does not use derivative financial instruments for speculative trading
purposes, it hedges its foreign currency exposure through the purchase of
forward contracts.
As of September 30, 2005, the Company has forward contracts outstanding of
approximately 6.1 million Euros. A one percent fluctuation in the Euro vs. U.S.
Dollar exchange rate would result in a gain or loss on Euro denominated accounts
payable of approximately $0.1 million with a corresponding gain or loss to the
forward contracts.
ITEM 4. CONTROLS AND PROCEDURES
DISCLOSURE CONTROLS AND PROCEDURES
The Company's management, with the participation of the Company's principal
executive and principal financial officers, has evaluated the effectiveness of
the Company's disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the
"Exchange Act")) as of September 30, 2005, and has concluded that the Company's
disclosure controls and procedures were not effective as of September 30, 2005
because of the material weakness in the Company's internal control over
financial reporting discussed below under "Internal Control Over Financial
Reporting."
INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company has determined that, as of December 31, 2004, it had a deficiency in
internal controls over the valuation of deferred income tax assets.
Specifically, the Company did not have adequate controls over the accounting for
and the review and approval of income tax related financial statement accounts
requiring a significant degree of technical knowledge related to deferred tax
assets and liabilities. As a result of the ineffective review, an error in the
deferred tax valuation allowance was not detected prior to the issuance of the
2004 consolidated financial statements. This control deficiency resulted in the
restatement of the Company's 2004 annual and first quarter 2005 consolidated
financial statements. In addition this control deficiency could result in a
misstatement to deferred tax valuation allowance that could result in a material
misstatement to the annual or interim financial statements. Accordingly,
management determined that this control deficiency constitutes a material
weakness. A material weakness is a control deficiency, or combination of control
deficiencies, that results in a more than remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected.
32
REMEDIATION PLAN
During the fiscal quarter ended September 30, 2005, the Company has taken
remedial steps to eliminate this material weakness, including engaging the
services of an independent public accounting firm with appropriate levels of
income tax accounting knowledge and expertise to assist in the review of complex
tax matters. As of September 30, 2005, these remediation efforts, and the
Company's evaluation of its internal controls over the valuation of deferred
income tax assets, are continuing.
CHANGES IN INTERNAL CONTROL
Other than as discussed in the preceding paragraph, there has been no change in
the Company's internal control over financial reporting (as defined in Rules
13a-15(f) and 15-d-15(f) under the Exchange Act) that occurred during the
Company's fiscal quarter ended September 30, 2005, that has materially affected,
or is reasonably likely to materially affect, the Company's internal control
over financial reporting.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
-----------------
Reference is made to the information contained in Note 14 to the Condensed
Consolidated Financial Statements included herein, which information is
incorporated herein by reference.
ITEM 6. EXHIBITS
--------
31.1 Certification by the Chief Executive Officer pursuant to
rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification by the Chief Financial Officer pursuant to
rule 13-14(a) or 15d-14(a) of the Securities Exchange Act of
1934, as adopted pursuant to section 302 of the
Sarbanes-Oxley Act of 2002.
33
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.
NORTH ATLANTIC HOLDING COMPANY, INC.
Date: November 14, 2005 /s/ Douglas P. Rosefsky
------------------------------------
Douglas P. Rosefsky
Chief Executive Officer
/s/ Brian C. Harriss
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Brian C. Harriss
Chief Financial Officer
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EXHIBIT INDEX
No. Description
--- -----------
31.1 Certification by the Chief Executive Officer pursuant to rule 13-14(a)
or 15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification by the Chief Financial Officer pursuant to rule 13-14(a)
or 15d-14(a) of the Securities Exchange Act of 1934, as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.
35