UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

For the quarterly period ended October 8, 2016

OR

For the transition period from                      to                     

Commission file number 1-16247

 

FLOWERS FOODS, INC.

(Exact name of registrant as specified in its charter)

 

 

1919 FLOWERS CIRCLE, THOMASVILLE, GEORGIA

(Address of principal executive offices)

31757

(Zip Code)

(229)-226-9110

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒ 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

 

 

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FLOWERS FOODS, INC.

INDEX

 

 

 

 

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Forward-Looking Statements

Statements contained in this filing and certain other written or oral statements made from time to time by the company and its representatives that are not historical facts are forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements relate to current expectations regarding our future financial condition and results of operations and are often identified by the use of words and phrases such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “should,” “will,” “would,” “is likely to,” “is expected to” or “will continue,” or the negative of these terms or other comparable terminology. These forward-looking statements are based upon assumptions we believe are reasonable.

Forward-looking statements are based on current information and are subject to risks and uncertainties that could cause our actual results to differ materially from those projected. Certain factors that may cause actual results, performance, liquidity, and achievements to differ materially from those projected are discussed in this report and may include, but are not limited to:

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The foregoing list of important factors does not include all such factors, nor necessarily present them in order of importance. In addition, you should consult other disclosures made by the company (such as in our other filings with the Securities and Exchange Commission (“SEC”) or in company press releases) for other factors that may cause actual results to differ materially from those projected by the company. Refer to Part I, Item 1A., Risk Factors, of our Annual Report on Form 10-K for the year ended on January 2, 2016 (the “Form 10-K”) and Part II, Item 1A., Risk Factors, of this Quarterly Report on Form 10-Q for the period ended October 8, 2016 (this “Form 10-Q”) for additional information regarding factors that could affect the company’s results of operations, financial condition and liquidity.

We caution you not to place undue reliance on forward-looking statements, as they speak only as of the date made and are inherently uncertain. The company undertakes no obligation to publicly revise or update such statements, except as required by law. You are advised, however, to consult any further public disclosures by the company (such as in our filings with the SEC or in company press releases) on related subjects.

We own or have rights to trademarks or trade names that we use in connection with the operation of our business, including our corporate names, logos and website names. In addition, we own or have the rights to copyrights, trade secrets and other proprietary rights that protect the content of our products and the formulations for such products. Solely for convenience, some of the trademarks, trade names and copyrights referred to in this Form 10-Q are listed without the ^©, ^® and ™ symbols, but we will assert, to the fullest extent under applicable law, our rights to our trademarks, trade names and copyrights.

 

 

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PART 1. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)

FLOWERS FOODS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share data)

(Unaudited)

 

 

(See Accompanying Notes to Condensed Consolidated Financial Statements)

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FLOWERS FOODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Amounts in thousands except per share data)

(Unaudited)

 

 

(See Accompanying Notes to Condensed Consolidated Financial Statements)

 

 

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FLOWERS FOODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Amounts in thousands)

(Unaudited)

 

 

(See Accompanying Notes to Condensed Consolidated Financial Statements)

 

 

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FLOWERS FOODS, INC.

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(Amounts in thousands, except share data)

(Unaudited)

 

 

(See Accompanying Notes to Condensed Consolidated Financial Statements)

 

 

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FLOWERS FOODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

(Unaudited)

 

 

(See Accompanying Notes to Condensed Consolidated Financial Statements)

 

 

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FLOWERS FOODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

 

1. BASIS OF PRESENTATION

INTERIM FINANCIAL STATEMENTS — The accompanying unaudited Condensed Consolidated Financial Statements of Flowers Foods, Inc. (the “company”, “Flowers Foods”, “Flowers”, “us”, “we”, or “our”) have been prepared by the company’s management in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information and applicable rules and regulations of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Accordingly, they do not include all of the information and footnotes required by GAAP for audited financial statements. In the opinion of management, the unaudited Condensed Consolidated Financial Statements included herein contain all adjustments (consisting of only normal recurring adjustments) necessary to state fairly the company’s financial position, the results of its operations and its cash flows. The results of operations for the twelve and forty weeks ended October 8, 2016 and October 10, 2015 are not necessarily indicative of the results to be expected for a full fiscal year. The Condensed Consolidated Balance Sheet at January 2, 2016 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements. These financial statements should be read in conjunction with the audited consolidated financial statements, and notes thereto, included in the company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2016.

ESTIMATES — The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The company believes the following critical accounting estimates affect its more significant judgments and estimates used in the preparation of its consolidated financial statements: revenue recognition, derivative instruments, valuation of long-lived assets, goodwill and other intangible assets, self-insurance reserves, income tax expense and accruals, pension obligations, stock-based compensation, and commitments and contingencies. These estimates are summarized in the company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2016.

REPORTING PERIODS — The company operates on a 52-53 week fiscal year ending the Saturday nearest December 31. Fiscal 2016 consists of 52 weeks, with the company’s quarterly reporting periods as follows: first quarter ended April 23, 2016 (sixteen weeks), second quarter ended July 16, 2016 (twelve weeks), third quarter ended October 8, 2016 (twelve weeks) and fourth quarter ending December 31, 2016 (twelve weeks).

SEGMENTS — Flowers Foods currently operates two business segments: a direct-store-delivery (“DSD”) segment (“DSD Segment”) and a warehouse delivery segment (“Warehouse Segment”). The DSD Segment (84% of total year to date sales) currently operates 39 plants that produce a wide variety of fresh bakery foods, including fresh breads, buns, rolls, tortillas, and snack cakes. These products are sold through a DSD route delivery system to retail and foodservice customers in the Southeast, Mid-Atlantic, New England, Southwest, California and select markets in Nevada, the Midwest and the Pacific Northwest. The Warehouse Segment (16% of total year to date sales) currently operates ten plants that produce snack cakes, breads and rolls for national retail, foodservice, vending, and co-pack customers and deliver through customers’ warehouse channels. The Warehouse Segment also operates one baking ingredient mix facility.

SIGNIFICANT CUSTOMER — Following is the effect our largest customer, Walmart/Sam’s Club, had on the company’s sales for the twelve and forty weeks ended October 8, 2016 and October 10, 2015. Walmart/Sam’s Club is the only customer to account for greater than 10% of the company’s sales.

 

 

Walmart/Sam’s Club is our only customer with a balance greater than 10% of outstanding trade receivables.  Their percentage of trade receivables was 18.1% and 18.9%, on a consolidated basis, as of October 8, 2016 and January 2, 2016, respectively.  No other customer accounted for greater than 10% of the company’s outstanding trade receivables.

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SIGNIFICANT ACCOUNTING POLICIES — There were no significant changes to our critical accounting policies for the quarter ended October 8, 2016 from those disclosed in the company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2016.

2. RECENT ACCOUNTING PRONOUNCEMENTS NOT YET ADOPTED

In May 2014, the Financial Accounting Standards Board (the “FASB”) issued guidance for recognizing revenue in contracts with customers. This guidance requires entities to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. There are five steps outlined in the guidance to achieve this core principle. This guidance was originally effective January 1, 2017, the first day of our fiscal 2017.  In July 2015, the FASB issued a deferral for one year, making the effective date December 31, 2017, the first day of our fiscal 2018.  In March 2016, the FASB amended the initial guidance to clarify the implementation guidance on principal versus agent considerations.  In April 2016, the FASB amended the initial guidance to clarify the identification of performance conditions and the licensing implementation guidance.  In May 2016, the FASB amended the initial guidance to update certain narrow scopes within the revenue recognition guidance.  Early application is permitted, but not before January 1, 2017.  Entities will have the option to apply the final standard retrospectively or use a modified retrospective method, recognizing the cumulative effect of the standards in retained earnings at the date of initial application.  An entity will not restate prior periods if uses the modified retrospective method, but will be required to disclose the amount by which each financial statement line item is affected in the current reporting period by the application of the standard as compared to the guidance in effect prior to the change, as well as reasons for significant changes.  The company intends to adopt the updated standard in the first quarter of fiscal 2018.  The company is currently evaluating the impact that implementing this standard will have on its financial statements and disclosures, as well as whether it will use the retrospective or modified retrospective method of adoption.  

In August, 2014 the FASB issued guidance that requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards.  Specifically, the amendments provide a definition of the term substantial doubt, require an evaluation every reporting period including interim periods, provide principles for considering the mitigating effect of management’s plans, require certain disclosures when substantial doubt is alleviated as a result of consideration of management’s plans, require an express statement and other disclosures when substantial doubt is not alleviated, and require an assessment for a period of one year after the date of that the financial statements are issued.  The amendments for this guidance are effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter.  The company intends to adopt the updated standard in the fourth quarter of fiscal 2016.  The company does not anticipate that this guidance will have a material impact on our Condensed Consolidated Financial Statements.

In July 2015, the FASB issued guidance that entities should measure inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.  This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. This guidance must be applied prospectively with earlier application permitted as of the beginning of an interim or annual reporting period.  The company is still analyzing the potential impact of this guidance on the company’s Condensed Consolidated Financial Statements.

In February 2016, the FASB issued guidance that requires an entity to recognize lease liabilities and a right-of-use asset for virtually all leases (other than those that meet the definition of a short-term lease) on the balance sheet and to disclose key information about the entity’s leasing arrangements.  This guidance is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period, with earlier adoption permitted.  This guidance must be adopted using a modified retrospective approach for all leases existing at, or entered into after the date of initial adoption, with an option to elect to use certain transition relief.  The company intends to adopt the updated standard in the first quarter of fiscal 2019.  The company is evaluating the potential impact of this guidance on our Condensed Consolidated Financial Statements.

In March 2016, the FASB issued guidance to simplify several aspects of the accounting for employee share-based payment transactions including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification in the statement of cash flows.  This guidance is effective for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years, and early adoption is permitted.  The company is evaluating the potential impact of this guidance on our Condensed Consolidated Financial Statements and the timing of when we will adopt the guidance.

In August 2016, the FASB issued guidance on the classification of certain cash receipts and payments in the statement of cash flows. The guidance is effective for fiscal years beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. The guidance must be applied retrospectively to all periods presented but may be applied prospectively if retrospective application would be impracticable. We are currently evaluating the impact that the new guidance will have on our Condensed Consolidated Financial Statements.

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We have reviewed other recently issued accounting pronouncements and concluded that they are either not applicable to our business or that no material effect is expected upon future adoption.

3. RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS

In April 2015, the FASB issued guidance to simplify the presentation of debt issuance costs.  This guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct reduction from the carrying amount of that debt liability, consistent with debt discount presentation.  This guidance is effective for financial statements for fiscal years beginning after December 15, 2015, and interim periods within those years.  This guidance is applied on a retrospective basis at adoption and the disclosures for a change in an accounting principle apply.  This guidance was adopted as of January 3, 2016 (the first day of our fiscal 2016) with application of the provisions retrospectively.  Debt issuance costs associated with line-of-credit arrangements is not addressed by this guidance.  The company’s accounts receivable securitization facility and credit facility, discussed in Note 9, Debt and Other Obligations, are excluded from this guidance and are still presented as other long-term assets in the Condensed Consolidated Balance Sheet.  As a result of adopting this standard, the debt issuance costs of our other debt obligations were reclassified as a reduction to the carrying amount of the debt liability for the Condensed Consolidated Balance Sheets as of July 16, 2016 and January 2, 2016.  The balance sheet as of January 2, 2016 was retrospectively adjusted, which resulted in a $3.9 million decrease to other non-current assets and to total long-term debt and capital lease obligations.

In November 2015, the FASB issued guidance that requires entities to report deferred tax liabilities and assets as noncurrent in a classified statement of financial position.  The previous requirement that deferred tax liabilities and assets of a tax-paying component of an entity be offset and presented as a single amount is not affected by this guidance.  This guidance is effective for fiscal years beginning after December 15, 2016, and interim periods within those annual periods.  Earlier application is permitted for all entities as of the beginning of an interim or annual reporting period.  The company adopted this standard for the annual period beginning on January 3, 2016 (the first day of our fiscal 2016) and applied it retrospectively.  As a result of adopting this standard, all deferred tax assets and liabilities have been classified as noncurrent for the Condensed Consolidated Balance Sheets as of October 8, 2016 and January 2, 2016.  The balance sheet as of January 2, 2016 was retrospectively adjusted, which resulted in a $37.2 million decrease in the current deferred income tax asset balance and in the long-term deferred income tax liability balance.

The table below presents the adjustments for each of the line items impacted for these pronouncements (amounts in thousands):

 

 

In September 2015, the FASB issued guidance that entities that have reported provisional amounts for items in a business combination for which the accounting is incomplete by the end of the reporting period in which the combination occurs and during the measurement period have an adjustment to provisional amounts recognized. This update requires that an acquirer recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined.  This guidance also requires that an entity present separately on the face of the income statement or disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date.  This guidance is effective for our fiscal 2016.  This is applied prospectively to adjustments to provisional amounts that occur after the effective date of the guidance.  The potential impact of the guidance on the company’s Condensed Consolidated Financial Statements will only be known after a measurement period adjustment for an acquisition is recognized.  The adoption of this guidance is presented in Note 6, Goodwill and Other Intangible Assets, for the measurement period adjustments related to the acquisitions discussed in Note 4, Acquisitions, below.

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4. ACQUISITIONS

Alpine Valley Bread Company

On October 13, 2015, the company completed the acquisition of 100% of the capital stock of Alpine Valley Bread Company (“Alpine”), a leading organic bread baker, from its shareholders for total consideration of approximately $121.9 million inclusive of payments for certain tax benefits.  We paid cash of $109.3 million and issued 481,540 shares of our common stock to the sellers in a private placement.  Alpine operates two production facilities in Mesa, Arizona and has widespread distribution across the U.S.  The Alpine acquisition has been accounted for as a business combination and is included in our Warehouse Segment. The results of Alpine’s operations were included in the company’s Condensed Consolidated Financial Statements beginning on October 14, 2015. The total preliminary goodwill recorded for this acquisition was $36.5 million and it is deductible for tax purposes.

During fiscal 2015, the company incurred $1.6 million of acquisition-related costs for Alpine. The acquisition-related costs for Alpine were recorded in the selling, distribution and administrative expense line item in our Condensed Consolidated Statements of Income. Alpine contributed $11.9 million in sales during fiscal 2015.  Alpine’s operating income since the acquisition was immaterial to our fiscal 2015 results of operations.

The following table summarizes the consideration paid for Alpine based on the fair value at the acquisition date.  This table is based on preliminary valuations for the assets acquired and liabilities assumed.  The identifiable intangible assets, property, plant and equipment, and certain financial assets and taxes are still under review.  We will continue reviewing the final recognized amounts of identifiable assets acquired and liabilities assumed until the fourth quarter of our fiscal 2016 when the allocation will be final (amounts in thousands):

 

 

The following table presents the acquired intangible assets subject to amortization (amounts in thousands, except amortization periods):

 

 

The fair value of trade receivables is $4.8 million with an immaterial amount determined to be uncollectible.  We did not acquire any other class of receivables as a result of the acquisition.

Dave’s Killer Bread

On September 12, 2015, the company completed the acquisition of 100% of the capital stock of Dave’s Killer Bread (“DKB”), the nation’s best-selling organic bread, from its shareholders for total cash payments of approximately $282.1 million inclusive of payments for certain tax benefits.  DKB operates one production facility in Milwaukie, Oregon and has widespread distribution across the U.S. We believe the acquisition of DKB strengthens our position as the second-largest baker in the U.S. by giving us access to the fast growing organic bread category and expanding our geographic reach into the Pacific Northwest. The DKB acquisition has been accounted for as a business combination and is included in our DSD Segment. The results of DKB’s operations are included in the company’s Condensed Consolidated Financial Statements beginning on September 13, 2015. The total goodwill recorded for this acquisition was $146.1 million and it is not deductible for tax purposes.

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During fiscal 2015, the company incurred $4.6 million of acquisition-related costs for DKB. The acquisition-related costs for DKB were recorded in the selling, distribution and administrative expense line item in our Condensed Consolidated Statements of Income. DKB contributed $37.6 million in sales during fiscal 2015.  DKB’s operating income since the acquisition was immaterial to our fiscal 2015 results of operations.

The following table summarizes the consideration paid for DKB based on the fair value at the acquisition date (amounts in thousands):  

 

 

The following table presents the acquired intangible assets subject to amortization (amounts in thousands, except amortization periods):  

 

 

The fair value of trade receivables is $14.2 million. The gross amount of the receivable is $14.4 million of which $0.2 million is determined to be uncollectible. We did not acquire any other class of receivables as a result of the acquisition.

Unaudited pro forma consolidated results of operations for the Alpine and DKB acquisitions are not included because the company determined that they are immaterial.

 

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5. ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) (“AOCI”)

The company’s total comprehensive income presently consists of net income, adjustments for our derivative financial instruments accounted for as cash flow hedges, and various pension and other postretirement benefit related items.

During the twelve and forty weeks ended October 8, 2016 and October 10, 2015, reclassifications out of accumulated other comprehensive loss were as follows (amounts in thousands):

 

 

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During the forty weeks ended October 8, 2016, changes to accumulated other comprehensive loss, net of income tax, by component were as follows (amounts in thousands and brackets denote a debit balance):

 

 

During the forty weeks ended October 10, 2015, changes to accumulated other comprehensive loss, net of income tax, by component were as follows (amounts in thousands and brackets denote a debit balance):

 

 

Amounts reclassified out of accumulated other comprehensive loss to net income that relate to commodity contracts are presented as an adjustment to reconcile net income to net cash provided by operating activities on the Condensed Consolidated Statements of Cash Flows. The following table presents the net of tax amount of the loss reclassified from accumulated other comprehensive income (“AOCI”) for our commodity contracts (amounts in thousands):

 

 

6. GOODWILL AND OTHER INTANGIBLE ASSETS

The table below summarizes our goodwill and other intangible assets at October 8, 2016 and January 2, 2016, respectively, each of which is explained in additional detail below (amounts in thousands):

 

 

The changes in the carrying amount of goodwill, by segment, during the forty weeks ended October 8, 2016 are as followings (amounts in thousands):

 

 

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The table below presents the changes to goodwill by acquisition from January 2, 2016 to October 8, 2016 (amounts in thousands):

 

 

As of October 8, 2016 and January 2, 2016, the company had the following amounts related to amortizable intangible assets (amounts in thousands):

 

 

Aggregate amortization expense for the twelve and forty weeks ended October 8, 2016 and October 10, 2015 was as follows (amounts in thousands):

 

 

There are $414.0 million of indefinite-lived intangible trademark assets separately identified from goodwill at October 8, 2016 and January 2, 2016. These trademarks are classified as indefinite-lived because we believe they are well established brands, many older than forty years old, with a long history and well defined markets.  In addition, we are continuing to use these brands both in their original markets and throughout our expansion territories. We believe these factors support an indefinite-life assignment. We perform an annual impairment analysis, or on interim basis if the facts and circumstances change, to determine if the trademarks are realizing the expected economic benefits.

During the fourth quarter of our fiscal 2015, we reviewed our long-term strategy for all of our organic bread brands due to the acquisitions of the DKB and Alpine organic brands in our third and fourth quarter, respectively, of fiscal 2015.  We previously acquired the Barowsky’s brand, which included certain organic products, in fiscal 2012.  We originally intended to distribute that brand nationally throughout the territories in our DSD Segment.  As a result of our strategic review, the DKB brand will be distributed through our DSD Segment and the Alpine brand will be distributed through our Warehouse Segment.  Accordingly, the Barowsky’s brand will remain primarily a regional bread brand for the northeast.  Since the Barowsky’s brand will not be used as originally intended, we examined the indefinite-life assignment and determined that it is appropriate to begin amortizing this brand.  Beginning in our fourth quarter of fiscal 2015, we began amortizing the Barowsky’s brand over a 35 year straight-line attribution period.  Because this change in strategy still reflects that the estimated fair value exceeds the carrying value, an impairment charge was not applicable.  We continue to monitor this and all of our finite-lived intangible assets for changes in the facts and circumstances that could impact the fair value.  

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Estimated amortization of intangibles for each of the next five years is as follows (amounts in thousands):

 

 

7. FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying value of cash and cash equivalents, accounts receivable, and short-term debt approximates fair value because of the short-term maturity of the instruments. Notes receivable are entered into in connection with the purchase of independent distributors’ distribution rights by independent distributors. These notes receivable are recorded in the Consolidated Balance Sheet at carrying value, which represents the closest approximation of fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. As a result, the appropriate interest rate that should be used to estimate the fair value of the distribution rights notes is the prevailing market rate at which similar loans would be made to independent distributors with similar credit ratings and for the same maturities. However, the company finances approximately 3,600 independent distributors all with varied financial histories and credit risks. Considering the diversity of credit risks among the independent distributors, the company has no method to accurately determine a market interest rate to apply to the notes. The distribution rights are generally financed for up to ten years and the distribution rights notes are collateralized by the independent distributors’ distribution rights. The company maintains a wholly-owned subsidiary to assist in financing the distribution rights purchase activities if requested by new independent distributors, using the distribution rights and certain associated assets as collateral. These notes receivable earn interest at a fixed rate.

Interest income for the distributor notes receivable was as follows (amounts in thousands):

 

 

At October 8, 2016, January 2, 2016, and October 10, 2015 respectively, the carrying value of the distributor notes was as follows (amounts in thousands):

 

 

At October 8, 2016 and January 2, 2016, the company has evaluated the collectability of the distributor notes and determined that a reserve is not necessary. Payments on these distributor notes are collected by the company weekly in conjunction with the distributor settlement process.

The fair value of the company’s variable rate debt at October 8, 2016 approximates the recorded value. The fair value of the company’s senior notes (“notes”), as discussed in Note 9, Debt and Other Obligations, are estimated using yields obtained from independent pricing sources for similar types of borrowing arrangements and are considered a Level 2 valuation. The fair value of the notes are presented in the table below (amounts in thousands, except level classification):

 

 

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For fair value disclosure information about our derivative assets and liabilities see Note 8, Derivative Financial Instruments.

8. DERIVATIVE FINANCIAL INSTRUMENTS

The company measures the fair value of its derivative portfolio by using the price that would be received to sell an asset or paid to transfer a liability in the principal market for that asset or liability. These measurements are classified into a hierarchy by the inputs used to perform the fair value calculation as follows:

Level 1: Fair value based on unadjusted quoted prices for identical assets or liabilities at the measurement date

Level 2: Modeled fair value with model inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly

Level 3: Modeled fair value with unobservable model inputs that are used to estimate the fair value of the asset or liability

Commodity Risk

The company enters into commodity derivatives designated as cash-flow hedges of existing or future exposure to changes in commodity prices. The company’s primary raw materials are flour, sweeteners and shortening, along with pulp, paper and petroleum-based packaging products. Natural gas, which is used as oven fuel, is also an important commodity input for production.

As of October 8, 2016, the company’s hedge portfolio contained commodity derivatives which are recorded in the following accounts with fair values measured as indicated (amounts in thousands):

 

 

As of January 2, 2016, the company’s commodity hedge portfolio contained derivatives which are recorded in the following accounts with fair values measured as indicated (amounts in thousands):

 

 

The positions held in the portfolio are used to hedge economic exposure to changes in various raw material prices and effectively fix the price, or limit increases in prices, for a period of time extending primarily into fiscal 2017. These instruments are designated as cash-flow hedges. The effective portion of changes in fair value for these derivatives is recorded each period in other comprehensive income (loss), and any ineffective portion of the change in fair value is recorded to current period earnings in selling, distribution and administrative expenses. All of the company-held commodity derivatives at October 8, 2016 and January 2, 2016 qualified for hedge accounting.

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Interest Rate Risk

The company entered into treasury rate locks on August 5, 2016 and August 8, 2016 to fix the interest rate for the 3.5% senior notes due 2026 (“2026 notes”) issued on September 28, 2016.  The derivative positions were closed when the debt was priced on September 23, 2016 with a cash settlement net receipt of $1.0 million that offset changes in the benchmark treasury rate between execution of the treasury rate locks and the debt pricing date.  These rate locks were designated as a cash flow hedge.  During the twelve and forty weeks ended October 8, 2016, the company recognized $0.1 million of ineffectiveness due to issuing the debt earlier than the settlement date of the treasury locks.  The ineffectiveness amount is reported as a selling, distribution, and administrative expense in our Condensed Consolidated Statements of Income.

The company entered into a treasury rate lock on March 28, 2012 to fix the interest rate for the 4.375% senior notes due 2022 (“2022 notes”) issued on April 3, 2012. The derivative position was closed when the debt was priced on March 29, 2012 with a cash settlement that offset changes in the benchmark treasury rate between the execution of the treasury rate lock and the debt pricing date. This treasury rate lock was designated as a cash flow hedge.

The following table outlines the company’s derivatives which were hedging the risk of changes in forecasted interest payments on forecasted issuance of long-term debt (amounts in thousands, before tax, and an asset is a positive value and a liability is a negative value):

 

 

Derivative Assets and Liabilities

The company has the following derivative instruments located on the Condensed Consolidated Balance Sheet, which are utilized for the risk management purposes detailed above (amounts in thousands):

 

 

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Derivative AOCI transactions

The company had the following derivative instruments for deferred gains and (losses) on closed contracts and the effective portion for changes in fair value recorded in AOCI (no amounts were excluded from the effectiveness test), all of which are utilized for the risk management purposes detailed above (amounts in thousands and net of tax):

 

 

There was no hedging ineffectiveness, and no amounts were excluded from the ineffectiveness testing, during the twelve and forty weeks ended October 8, 2016 and October 10, 2015, respectively, related to the company’s commodity risk hedges.

The balance in accumulated other comprehensive loss related to commodity price risk and interest rate risk derivative transactions that are closed or will expire over the following years are as follows (amounts in thousands and net of tax)(amounts in parenthesis indicate a debit balance) at October 8, 2016:

 

 

Derivative Transactions Notional Amounts

As of October 8, 2016, the company had the following outstanding financial contracts that were entered to hedge commodity risk (amounts in thousands):

 

 

The company’s derivative instruments contain no credit-risk related contingent features at October 8, 2016.  As of October 8, 2016 and January 2, 2016, the company had $9.8 million and $20.7 million, respectively, in other current assets representing collateral for hedged positions.

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9. DEBT AND OTHER OBLIGATIONS

Long-term debt and capital leases (net of issuance costs and debt discounts excluding line-of-credit arrangements) consisted of the following at October 8, 2016 and January 2, 2016 (amounts in thousands):

 

 

Bank overdrafts occur when checks have been issued but have not been presented to the bank for payment. Certain of our banks allow us to delay funding of issued checks until the checks are presented for payment. The delay in funding results in a temporary source of financing from the bank. The activity related to bank overdrafts is shown as a financing activity in our Condensed Consolidated Statements of Cash Flows. Bank overdrafts are included in other current liabilities on our Condensed Consolidated Balance Sheets. As of October 8, 2016 and January 2, 2016, the bank overdraft balance was $12.4 million and $18.0 million, respectively.

The company also had standby letters of credit (“LOCs”) outstanding of $16.3 million and $16.9 million at October 8, 2016 and January 2, 2016, respectively, which reduce the availability of funds under the credit facility. The outstanding LOCs are for the benefit of certain insurance companies and lessors. None of the LOCs are recorded as a liability on the Condensed Consolidated Balance Sheet.

2026 Notes, 2016 Term Loan, Accounts Receivable Securitization Facility, 2013 Term Loan, 2022 Notes, and Credit Facility

2026 Notes. On September 28, 2016, the company issued $400.0 million of senior notes (the “2026 notes”). The company will pay semiannual interest on the 2026 notes on each April 1 and October 1, beginning on April 1, 2017, and the 2026 notes will mature on October 1, 2026. The notes bear interest at 3.500% per annum. The 2026 notes are subject to interest rate adjustments if either Moody’s or S&P downgrades (or downgrades and subsequently upgrades) the credit rating assign to the 2026 notes.  On any date prior to July 1, 2026, the company may redeem some or all of the notes at a price equal to the greater of (1) 100% of the principal amount of the notes redeemed and (2) a “make-whole” amount plus, in each case, accrued and unpaid interest. The make-whole amount is equal to the sum of the present values of the remaining scheduled payments of principal and interest on the 2026 notes to be redeemed that would be due if such notes matured July 1, 2026 (exclusive of interest accrued to, but not including, the date of redemption), discounted to the date of redemption on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the treasury rate (as defined in the indenture governing the notes), plus 30 basis points, plus in each case accrued and unpaid interest. At any time on or after July 1, 2026, the company may redeem some or all of the 2026 notes at a price equal to 100% of the principal amount of the notes redeemed plus accrued and unpaid interest. If the company experiences a “change of control triggering event” (which involves a change of control of the company and related rating of the notes below investment grade), it is required to offer to purchase the notes at a purchase price equal to 101% of the principal amount, plus accrued and unpaid interest thereon unless the company exercised its option to redeem the notes in whole.  The 2026 notes are also subject to customary restrictive covenants, including certain limitations on liens and sale and leaseback transactions.

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The face value of the 2026 notes is $400.0 million.  There was a debt discount representing the difference between the net proceeds, after expenses, received upon issuance of debt and the amount repayable at its maturity. The company also paid issuance costs (including underwriting fees and legal fees) on the 2026 notes. Debt issuance costs and the debt discount are being amortized to interest expense over the term of the 2026 notes. As of October 8, 2016, the company was in compliance with all restrictive covenants under the indenture governing the 2026 notes.  The table below presents the debt discount, underwriting fees and the legal and other fees for issuing the 2026 notes (amounts in thousands):  

 

 

2016 Term Loan. We entered into an unsecured term facility (the “2016 term loan”) on April 19, 2016.  The 2016 term loan provided for a five-year, syndicated, unsecured term loan pursuant to which we may incur term loan borrowings in a single draw up to an aggregate principal amount of $150.0 million.  The proceeds of the 2016 term loan borrowings were used to finance working capital and for general corporate purposes and to pay fees and expenses related to the 2016 term loan.  The company drew down the full amount of the 2016 term loan at execution. The company paid financing costs of $0.6 million in connection with the 2016 term loan.

The 2016 term loan was paid off in full at the time the company entered into the 2026 notes. The payoff was accounted for as an extinguishment of debt with the loss on extinguishment recorded as interest expense.  The extinguishment loss of $0.6 million was immediately recognized at the time the 2016 term loan was paid off. The company has no further obligations under this agreement.

Accounts Receivable Securitization Facility. On July 17, 2013, the company entered into an accounts receivable securitization facility (the “facility”). On August 7, 2014, the company entered into an amendment to the facility. The amendment (i) increased the revolving commitments under the facility to $200.0 million from $150.0 million, (ii) extended the term one year to July 17, 2016, and (iii) made certain other conforming changes. On December 17, 2014, the company executed a second amendment to the facility to add a bank to the lending group. The original commitment amount was split between the original lender and the new lender in the proportion of 62.5% for the original lender and 37.5% for the new lender. This modification, which was accounted for as an extinguishment of the debt, resulted in a charge of $0.1 million, or 37.5%, of the unamortized financing costs. On August 20, 2015, the company executed a third amendment to the facility to extend the term to August 11, 2017 and to add a leverage pricing grid.  This amendment was accounted for as a modification.  On September 30, 2016, the company executed a fourth amendment to the facility to extend the term to September 28, 2018.  This amendment was accounted for as a modification.

Under the facility, a wholly-owned, bankruptcy-remote subsidiary purchases, on an ongoing basis, substantially all trade receivables. As borrowings are made under the facility, the subsidiary pledges the receivables as collateral. In the event of liquidation of the subsidiary, its creditors would be entitled to satisfy their claims from the subsidiary’s pledged receivables prior to distributions of collections to the company. We include the subsidiary in our Condensed Consolidated Financial Statements. The facility contains certain customary representations and warranties, affirmative and negative covenants, and events of default. There was $140.0 million outstanding under the facility as of October 8, 2016 and $170.0 million outstanding under the facility as of January 2, 2016.  As of October 8, 2016 and January 2, 2016, the company was in compliance with all restrictive covenants under the facility.  The company currently has $54.2 million available under its facility for working capital and general corporate purposes.  Amounts available for withdrawal under the facility are determined as the lesser of the total commitments and a formula derived amount based on qualifying trade receivables.

Optional principal repayments may be made at any time without premium or penalty. Interest is due two days after our reporting periods end in arrears on the outstanding borrowings and is computed as the cost of funds rate plus an applicable margin of 70 to 100 basis points based on leverage. An unused fee of 25 to 35 basis points is applicable on the unused commitment at each reporting period based on leverage. The company paid financing costs of $0.8 million in connection with the facility at the time we entered into the facility, which are being amortized over the life of the facility. During fiscal 2014, we incurred $0.2 million in financing costs with the first and second amendments. An additional $0.1 million in financing costs was paid during fiscal 2015 for the second and third amendments.   An additional $0.1 million in financing costs was paid during fiscal 2016 for the fourth amendment.

2013 Term Loan. We entered into a senior unsecured delayed-draw term facility (the “2013 term loan”) on April 5, 2013 with a commitment of up to $300.0 million. The company drew down the full amount of the 2013 term loan on July 18, 2013 (the “borrowing date”).

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The 2013 term loan was paid off in full on September 28, 2016, at the time the company entered into the 2026 notes.   The company has no further obligations under this agreement.  The payoff was accounted for as an extinguishment of debt with the loss on extinguishment recorded as interest expense.  The extinguishment loss of $1.3 million was recognized at the time the 2013 term loan was paid off.

2022 Notes. On April 3, 2012, the company issued $400.0 million of senior notes (the “2022 notes”). The company pays semiannual interest on the 2022 notes on each April 1 and October 1, beginning on October 1, 2012, and the 2022 notes will mature on April 1, 2022. The 2022 notes bear interest at 4.375% per annum. On any date prior to January 1, 2022, the company may redeem some or all of the 2022 notes at a price equal to the greater of (1) 100% of the principal amount of the notes redeemed and (2) a “make-whole” amount plus, in each case, accrued and unpaid interest. The make-whole amount is equal to the sum of the present values of the remaining scheduled payments of principal thereof (not including any interest accrued thereon to, but not including, the date of redemption), discounted to the date of redemption on a semi-annual basis (assuming a 360-day year consisting of twelve 30-day months) at the treasury rate (as defined in the indenture governing the notes), plus 35 basis points, plus in each case, unpaid interest accrued thereon to, but not including, the date of redemption. At any time on or after January 1, 2022, the company may redeem some or all of the 2022 notes at a price equal to 100% of the principal amount of the 2022 notes redeemed plus accrued and unpaid interest. If the company experiences a “change of control triggering event” (which involves a change of control of the company and related rating of the notes below investment grade), it is required to offer to purchase the 2022 notes at a purchase price equal to 101% of the principal amount, plus accrued and unpaid interest thereon unless the company exercised its option to redeem the 2022 notes in whole. The 2022 notes are also subject to customary restrictive covenants, including certain limitations on liens and sale and leaseback transactions.

The face value of the 2022 notes is $400.0 million and the debt discount on the 2022 notes at issuance was $1.0 million. The company paid issuance costs (including underwriting fees and legal fees) on the 2022 notes of $3.9 million. The issuance costs and the debt discount are being amortized to interest expense over the term of the 2022 notes. As of October 8, 2016 and January 2, 2016, the company was in compliance with all restrictive covenants under the indenture governing the 2022 notes.

Credit Facility. On April 19, 2016, the company amended its senior unsecured credit facility (the “credit facility”), which was accounted for as a modification of the debt, that addressed changes in law affecting the terms of the existing agreement, makes certain terms of the existing agreement consistent with the terms of the 2016 term loan, and amends the terms to permit the indebtedness to be incurred under the 2016 term loan.  In addition, the amendment increases the highest applicable margin applicable to base rate loans to 0.75% and the Eurodollar rate loans to 1.75%, in each case, based on the leverage ratio of the company.  It also increases the highest applicable facility fee to 0.50%, due quarterly on all commitments under the facility.  Previously, on April 21, 2015, the company amended the credit facility to extend the term to April 21, 2020, reduce the applicable margin on base rate and Eurodollar loans and reduce the facility fees, described below. The April 21, 2015 amendment was accounted for as a modification of the debt. The credit facility is a five-year, $500.0 million senior unsecured revolving loan facility. The credit facility contains a provision that permits us to request up to $200.0 million in additional revolving commitments, for a total of up to $700.0 million, subject to the satisfaction of certain conditions. Proceeds from the credit facility may be used for working capital and general corporate purposes, including capital expenditures, acquisition financing, refinancing of indebtedness, dividends and share repurchases. The credit facility includes certain customary restrictions, which, among other things, require maintenance of financial covenants and limit encumbrance of assets and creation of indebtedness. Restrictive financial covenants include such ratios as a minimum interest coverage ratio and a maximum leverage ratio. The company believes that, given its current cash position, its cash flow from operating activities and its available credit capacity, it can comply with the current terms of the amended credit facility and can meet presently foreseeable financial requirements. As of October 8, 2016 and January 2, 2016, the company was in compliance with all restrictive covenants under the credit facility.

Interest is due quarterly in arrears on any outstanding borrowings at a customary Eurodollar rate or the base rate plus applicable margin. The underlying rate is defined as rates offered in the interbank Eurodollar market, or the higher of the prime lending rate or the federal funds rate plus 0.50%, with a floor rate defined by the one-month interbank Eurodollar market rate plus 1.00%. The applicable margin ranges from 0.0% to 0.75% for base rate loans and from 0.70% to 1.75% for Eurodollar loans. In addition, a facility fee ranging from 0.05% to 0.50% is due quarterly on all commitments under the credit facility. Both the interest margin and the facility fee are based on the company’s leverage ratio.

The company paid additional financing costs of $0.4 million in connection with the April 21, 2015 amendment of the credit facility, which, in addition to the remaining balance of the original financing costs, is being amortized over the life of the credit facility.  

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The highest outstanding daily balance during the forty weeks ended October 8, 2016 was $244.2 million and the lowest outstanding balance was zero. Amounts outstanding under the credit facility vary daily. Changes in the gross borrowings and repayments can be caused by cash flow activity from operations, capital expenditures, acquisitions, dividends, share repurchases, and tax payments, as well as derivative transactions which are part of the company’s overall risk management strategy as discussed in Note 8, Derivative Financial Instruments. During the forty weeks ended October 8, 2016, the company borrowed $1,267.7 million in revolving borrowings under the credit facility and repaid $1,417.2 million in revolving borrowings. The amount available under the credit facility is reduced by $16.3 million for letters of credit. On October 8, 2016, the company had $473.2 million available under its credit facility for working capital and general corporate purposes.

Credit Ratings.  Currently, the company’s credit ratings by Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s are BBB, Baa2, and BBB, respectively. Changes in the company’s credit ratings do not trigger a change in the company’s available borrowings or costs under the 2026 notes, facility, 2022 notes, or credit facility, but could affect future credit availability and cost.

Assets recorded under capital lease agreements included in property, plant and equipment consist of machinery and equipment and transportation equipment.

Aggregate maturities of debt outstanding, including capital leases and the associated interest, as of October 8, 2016, are as follows (excluding unamortized debt discount and issuance costs) (amounts in thousands):

 

 

The company adopted guidance, as discussed in Note 3, Recently Adopted Accounting Pronouncements, that requires debt issuances costs be presented in the balance sheet as a direct reduction from the carrying amount of the liability.  The table below reconciles the debt issuance costs and debt discounts to the net carrying value of each of our debt obligations (excluding line-of-credit arrangements) at October 8, 2016 (amounts in thousands):

 

 

The table below reconciles the debt issuance costs and debt discounts to the net carrying value of each of our debt obligations (excluding line-of-credit arrangements) at January 2, 2016 (amounts in thousands):

 

 

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10. VARIABLE INTEREST ENTITIES

Transportation agreement variable interest entity (the “VIE”) analysis

The company maintains a transportation agreement with an entity that transports a significant portion of the company’s fresh bakery products from the company’s production facilities to outlying distribution centers. The company represents a significant portion of the entity’s revenue. This entity qualifies as a VIE, but the company has determined it is not the primary beneficiary of the VIE. The company is not considered to be the primary beneficiary of the VIEs because the company does not (i) have the ability to direct the significant activities of the VIEs and (ii) provide any implicit or explicit guarantees or other financial support to the VIEs for specific return or performance benchmarks. In addition, we do not provide, nor do we intend to provide, financial or other support to the entity.

The company has concluded that certain of the trucks and trailers the VIE uses for distributing our products from the manufacturing facilities to the distribution centers qualify as right to use leases. As of October 8, 2016 and January 2, 2016, there was $31.9 million and $20.2 million, respectively, in net property, plant and equipment and capital lease obligations associated with the right to use leases.

Distribution rights agreement VIE analysis

The incorporated independent distributors (“IDs”) in the DSD Segment qualify as VIEs. The independent distributors who are formed as sole proprietorships are excluded from the following VIE accounting analysis and discussion.  

The company typically finances the IDs’ acquisition of the distribution rights and also enters into a contract with the ID to sell product at a discount for distribution in the IDs’ territory covered by their distribution rights. The combination of the company’s loans to the IDs and the ongoing supply arrangements with the IDs provide a level of protection and funding to the equity owners of the various IDs that would not otherwise be available. As of October 8, 2016 and January 2, 2016, there was $70.2 million and $50.8 million, respectively, in gross distribution rights notes receivable outstanding for IDs.

The company is not considered to be the primary beneficiary of the VIEs because the company does not (i) have the ability to direct the significant activities of the VIEs that would affect their ability to operate their respective independent distributor territories and (ii) provide any implicit or explicit guarantees or other financial support to the VIEs, other than the financing described above, for specific return or performance benchmarks. The activities controlled by the IDs that are deemed to most significantly impact the ultimate success of the ID entities relate to those decisions inherent in operating the distribution business in the territory, including acquiring trucks and trailers, managing fuel costs, employee matters and other strategic decisions. In addition, we do not provide, nor do we intend to provide, financial or other support to the IDs. The IDs are responsible for the operations of their respective territories including ordering of products.

The company’s maximum contractual exposure to loss for the IDs relates to the distributor rights note receivable for the portion of the territory the IDs financed at the time they acquired the distribution rights. The IDs remit payment on their distributor rights note receivable each week during the settlement process of their weekly activity.  In the event the IDs abandon their territory and have a remaining balance outstanding on the distribution rights note receivable, we will take the distribution rights back from the IDs (recording the distribution rights as assets held for sale) and subsequently sell the distribution rights to another independent distributor. The company’s collateral from the territory distribution rights mitigates potential losses.

11. LITIGATION

The company and its subsidiaries from time to time are parties to, or targets of, lawsuits, claims, investigations and proceedings, which are being handled and defended in the ordinary course of business. While the company is unable to predict the outcome of these matters, it believes, based upon currently available facts, that it is remote that the ultimate resolution of any such pending matters will have a material adverse effect on its overall financial condition, results of operations or cash flows in the future. However, adverse developments could negatively impact earnings in a particular future fiscal period.

The company’s facilities are subject to various federal, state and local laws and regulations regarding the discharge of material into the environment and the protection of the environment in other ways. The company is not a party to any material proceedings arising under these regulations. The company believes that compliance with existing environmental laws and regulations will not materially affect the consolidated financial condition, results of operations, cash flows or the competitive position of the company. The company believes it is currently in substantial compliance with all material environmental regulations affecting the company and its properties.  On August 9, 2016, the U.S. Department of Labor (the “DOL”) notified the company that it was scheduled for a compliance review under the Fair Labor Standards Act.  The company is cooperating with the DOL.

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At this time, the company is defending 24 complaints filed by distributors alleging that such distributors were misclassified as independent contractors.  Eighteen of these lawsuits seek class and/or collective action treatment. The remaining six cases allege individual claims and do not seek class or collective action treatment. The respective courts have ruled on plaintiffs’ motions for class certification in six of the pending cases, each of which is discussed below:

The company and/or its respective subsidiaries are vigorously defending all of these lawsuits. Given the stage of the complaints and the claims and issues presented, except for lawsuits disclosed herein that have reached a settlement or agreement in principle, the company cannot reasonably estimate at this time the possible loss or range of loss, if any, that may arise from the unresolved lawsuits.

On November 8, 2016, Flowers Foods' subsidiary, Lepage Bakeries, reached an agreement to settle a lawsuit seeking class action treatment (Bokanoski et al. v. Lepage Bakeries Park Street, LLC and CK Sales Co., LLC), originally filed by Bart Bokanoski and certain other plaintiffs in the U.S. District Court for the District of Connecticut on January 6, 2015, for $1.25 million, including attorneys' fees. The settlement also includes certain non-economic terms which are intended to strengthen and enhance the independent contractor model. This agreement, which includes 49 territories, is subject to court approval.  This settlement is recorded in selling, distribution and administrative expenses in our Condensed Consolidated Statements of Income for the twelve and forty weeks ended October 8, 2016.

On August 12, 2016, a class action complaint was filed in the U.S. District Court for the Southern District of New York by Chris B. Hendley (the “Hendley complaint”) against the company and certain senior members of management (collectively, the “defendants”). On August 17, 2016, another class action complaint was filed in the U.S. District Court for the Southern District of New York by Scott Dovell, II (the “Dovell complaint” and together with the Hendley complaint, the “complaints”) against the defendants. Plaintiffs in the complaints are securities holders that acquired company securities between February 7, 2013 and August 10, 2016. The complaints generally allege that the defendants made materially false and/or misleading statements and/or failed to disclose that (1) the company’s labor practices were not in compliance with applicable federal laws and regulations; (2) such non-compliance exposed the company to legal liability and/or negative regulatory action; and (3) as a result, the defendants’ statements about the company’s business, operations, and prospects were false and misleading and/or lacked a reasonable basis. The counts of the complaints are asserted against the defendants pursuant to Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5 under the Exchange Act. The complaints seek (1) class certification under the Federal Rules of Civil Procedure, (2) compensatory damages in favor of the plaintiffs and all other class members against the defendants, jointly and severally, for all damages sustained as a result of wrongdoing, in an amount to be proven at trial, including interest, and (3) awarding plaintiffs and the class their reasonable costs and expenses incurred in the actions, including counsel and expert fees. The company and/or its respective subsidiaries are vigorously

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defending these lawsuits. Given the stage of the complaints and the claims and issues presented, the company cannot reasonably estimate at this time the possible loss or range of loss, if any, that may arise from the unresolved lawsuits.

12. EARNINGS PER SHARE

The following is a reconciliation of net income and weighted average shares for calculating basic and diluted earnings per common share for the twelve and forty weeks ended October 8, 2016 and October 10, 2015 (amounts and shares in thousands, except per share data):

 

 

There were no anti-dilutive shares during the twelve and forty weeks ended October 8, 2016 and October 10, 2015.

 

 

13. STOCK-BASED COMPENSATION

On March 5, 2014, our Board of Directors approved and adopted the 2014 Omnibus Equity and Incentive Compensation Plan (“Omnibus Plan”). The Omnibus Plan was approved by our shareholders on May 21, 2014. The Omnibus Plan authorizes the compensation committee of the Board of Directors to provide equity-based compensation in the form of stock options, stock appreciation rights, restricted stock, restricted stock units, performance shares, performance units, dividend equivalents and other awards for the purpose of providing our officers, key employees, and non-employee directors’ incentives and rewards for performance. The Omnibus Plan replaced the Flowers Foods’ 2001 Equity and Performance Incentive Plan, as amended and restated as of April 1, 2009 (“EPIP”), the stock appreciation right plan, and the bonus plan. All outstanding equity awards that were made under the EPIP will continue to be governed by the EPIP; however, all equity awards granted after May 21, 2014 are governed by the Omnibus Plan. No additional awards will be issued under the EPIP. Awards granted under the Omnibus Plan are limited to the authorized amount of 8,000,000 shares.

The EPIP authorized the compensation committee of the Board of Directors to make awards of options to purchase our common stock, restricted stock, performance stock and units and deferred stock. The company’s officers, key employees and non-employee directors (whose grants are generally approved by the full Board of Directors) were eligible to receive awards under the EPIP. Over the life of the EPIP, the company issued options, restricted stock and deferred stock.

The following is a summary of stock options, restricted stock, and deferred stock outstanding under the plans described above. Information relating to the company’s stock appreciation rights, which were issued under a separate stock appreciation right plan, is also described below.

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Stock Options

The company issued non-qualified stock options (“NQSOs”) during fiscal years 2011 and prior that have no additional service period remaining. All outstanding NQSOs have vested and are exercisable on October 8, 2016.

The stock option activity for the forty weeks ended October 8, 2016 pursuant to the EPIP is set forth below (amounts in thousands, except price data):

 

 

As of October 8, 2016, compensation expense related to the NQSOs was fully amortized.  The cash received, the windfall tax benefit, and intrinsic value from stock option exercises for the forty weeks ended October 8, 2016 and October 10, 2015 were as follows (amounts in thousands):

 

 

Performance-Contingent Restricted Stock Awards

Performance-Contingent Total Shareholder Return Shares (“TSR Shares”)

Since 2012, certain key employees have been granted performance-contingent restricted stock under the EPIP and the Omnibus Plan in the form of TSR Shares. The awards generally vest approximately two years from the date of grant (after the filing of the company’s Annual Report on Form 10-K), and the shares become non-forfeitable if, and to the extent that, on that date the vesting conditions are satisfied. As a result of the delay (July as opposed to January) in the grant of the 2012 awards, the 2012 awards vested during the first quarter of 2014, 18 months from the grant date. The 2013, 2014, 2015 and 2016 awards (granted during the first quarters of their respective years) vest two years from the date of grant. The total shareholder return (“TSR”) is the percent change in the company’s stock price over the measurement period plus the dividends paid to shareholders. The performance payout is calculated at the end of each of the last four quarters (averaged) in the measurement period. Once the TSR is determined for the company (“Company TSR”), it is compared to the TSR of our food company peers (“Peer Group TSR”). The Company TSR compared to the Peer Group TSR will determine the payout as set forth below:

 

 

For performance between the levels described above, the degree of vesting is interpolated on a linear basis. The 2014 award vested at 27% of target.  The 2013 award vested at 88% of target.

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The TSR shares vest immediately if the grantee dies or becomes disabled. However, if the grantee retires at age 65 (or age 55 with at least 10 years of service with the company) or later, on the normal vesting date the grantee will receive a pro-rated number of shares based upon the retirement date and measured at the actual performance for the entire performance period. In addition, if the company undergoes a change in control, the TSR shares will immediately vest at the target level, provided that if 12 months of the performance period have been completed, vesting will be determined based on Company TSR as of the date of the change in control without application of four-quarter averaging. During the vesting period, the grantee has none of the rights of a shareholder. Dividends declared during the vesting period will accrue and will be paid at vesting on the shares that ultimately vest. The fair value estimate was determined using a Monte Carlo simulation model, which utilizes multiple input variables to estimate the probability of the company achieving the market condition discussed above. Inputs into the model included the following for the company and comparator companies: (i) TSR from the beginning of the performance cycle through the measurement date; (ii) volatility; (iii) risk-free interest rates; and (iv) the correlation of the comparator companies’ TSR. The inputs are based on historical capital market data.

The following performance-contingent TSR Shares have been granted under the Omnibus Plan and have service period remaining (amounts in thousands, except price data):

 

 

Performance-Contingent Return on Invested Capital Shares (“ROIC Shares”)

Since 2012, certain key employees have been granted performance-contingent restricted stock under the EPIP and the Omnibus Plan in the form of ROIC Shares. The awards generally vest approximately two years from the date of grant (after the filing of the company’s Annual Report on Form 10-K), and the shares become non-forfeitable if, and to the extent that, on that date, the vesting conditions are satisfied. As a result of the delay (July as opposed to January) in the grant of the 2012 awards, the 2012 awards vested during the first quarter of 2014, 18 months from the grant date. The 2013, 2014, 2015, and 2016 awards (granted during the first quarters of their respective years) vest two years from the date of grant. Return on Invested Capital is calculated by dividing our profit, as defined, by the invested capital (“ROIC”). Generally, the performance condition requires the company’s average ROIC to exceed its average weighted cost of capital (“WACC”) by between 1.75 to 4.75 percentage points (the “ROI Target”) over the two fiscal year performance period. If the lowest ROI Target is not met, the awards are forfeited. The shares can be earned based on a range from 0% to 125% of target as defined below:

For performance between the levels described above, the degree of vesting is interpolated on a linear basis. The 2014 award actual attainment was 96% of ROI Target.  The 2013 award actual attainment was 125% of ROI Target.

The ROIC Shares vest immediately if the grantee dies or becomes disabled. However, if the grantee retires at age 65 (or age 55 with at least 10 years of service with the company) or later, on the normal vesting date the grantee will receive a pro-rated number of shares based upon the retirement date and actual performance for the entire performance period. In addition, if the company undergoes a change in control, the ROIC Shares will immediately vest at the target level. During the vesting period, the grantee has none of the rights of a shareholder. Dividends declared during the vesting period will accrue and will be paid at vesting on the shares that ultimately vest. The fair value of this type of award is equal to the stock price on the grant date. Since these awards have a performance condition feature the expense associated with these awards may change depending on the expected ROI Target attained at each reporting period.  The 2015 award is being expensed at 105% of ROI Target and the 2016 award is being expensed at 100% of ROI Target. The following performance-contingent ROIC Shares have been granted under the Omnibus Plan and have service period remaining (amounts in thousands, except price data):

 

 

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Performance-Contingent Restricted Stock (2014 Grant)

In connection with the vesting of the performance-contingent restricted stock granted in January 2014, during the forty weeks ended October 8, 2016, 248,872 common shares available for this grant were reduced because the company attained only 27% of the S&P TSR target of the grant (“TSR modifier”). An additional 13,637 common shares were reduced because the company attained 96% of the ROI Target (“ROIC modifier”). At vesting, the company paid accumulated dividends of $0.4 million. The tax shortfall at vesting of these awards was $2.9 million.

Performance-Contingent Restricted Stock

The company’s performance-contingent restricted stock activity for the forty weeks ended October 8, 2016, is presented below (amounts in thousands, except price data):  

 

 

As of October 8, 2016, there was $14.4 million of total unrecognized compensation cost related to nonvested restricted stock granted under the Omnibus Plan. That cost is expected to be recognized over a weighted-average period of 1.18 years. The total intrinsic value of shares vested during the period ended October 8, 2016 was $7.2 million.

Deferred and Restricted Stock

Pursuant to the EPIP, previously the company allowed non-employee directors to convert their annual board retainers into deferred stock equal in value to 130% of the cash payments these directors would have otherwise received. The deferred stock had a minimum two-year vesting period and will be distributed to the individual (along with accumulated dividends) at a time designated by the individual at the date of conversion. Following the May 2014 Board of Directors meeting and the adoption of the Omnibus Plan, annual board retainers converted into deferred stock and issued under the Omnibus Plan are equal in value to 100% of the cash payments directors would otherwise receive and the vesting period is a one-year period to match the period of time that cash would have been received if no conversion existed. Going forward, under the Omnibus Plan, non-employee directors may elect to convert their annual board retainers into deferred stock equal in value to 100% of the cash payments they otherwise would have received. The deferred stock so converted will have a one-year pro-rated vesting period. Accumulated dividends are paid upon delivery of the shares.  During fiscal 2016, non-employee directors deferred an aggregate of 19,040 common shares for board retainer deferrals pursuant to the Omnibus Plan.

Pursuant to the Omnibus Plan and the EPIP, non-employee directors also receive annual grants of deferred stock. This deferred stock vests over one year from the grant date. During fiscal 2016, non-employee directors were granted an aggregate of 76,274 common shares of deferred stock pursuant to the Omnibus Plan. The deferred stock will be distributed to the grantee at a time designated by the grantee at the date of grant. Compensation expense is recorded on this deferred stock over the one-year minimum vesting period.

On May 31, 2013, the company’s Chief Executive Officer (“CEO”) received a time-based restricted stock award of approximately $1.3 million of restricted stock pursuant to the EPIP. This award will vest 100% on the fourth anniversary of the date of the grant provided the CEO remains employed by the company during this period and the award value does not exceed 0.5% of our cumulative EBITDA over the vesting period. Vesting will also occur in the event of the CEO’s death or disability, but not his retirement. Dividends will accrue on the award and will be paid to the CEO on the vesting date for all shares that vest. There were 58,500 shares issued for this award at a fair value of $22.25 per share.

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The deferred stock activity for the forty weeks ended October 8, 2016 is set forth below (amounts in thousands, except price data):  

 

 

As of October 8, 2016, there was $1.2 million of total unrecognized compensation cost related to deferred stock awards granted under the Ominbus Plan that will be recognized over a weighted-average period of 0.61 years.  The total intrinsic value of shares vested during the period ended October 8, 2016 was less than $1.3 million.

Stock Appreciation Rights

Prior to 2007, the company allowed non-employee directors to convert their retainers and committee chair fees into rights. These rights vested after one year and were exercisable over nine years. The company recorded compensation expense for these rights at a measurement date based on changes between the grant price and an estimated fair value of the rights using the Black-Scholes option-pricing model.  All remaining shares outstanding at January 2, 2016 were exercised during the forty weeks ended October 8, 2016.

Share-Based Payments Compensation Expense Summary

The following table summarizes the company’s stock based compensation expense for the twelve and forty weeks ended October 8, 2016 and October 10, 2015, respectively (amounts in thousands):

 

 

14. POST-RETIREMENT PLANS

The following summarizes the company’s balance sheet related pension and other post-retirement benefit plan accounts at October 8, 2016 as compared to accounts at January 2, 2016 (amounts in thousands):

 

 

Defined Benefit Plans and Nonqualified Plan

The company amended our qualified defined benefit plans in October 2015 to allow pension plan participants not yet receiving benefit payments the option to elect to receive their benefit as a single lump sum payment. This amendment was effective as of January 1, 2016.  This change supports our long-term pension risk management strategy.

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Settlement accounting, which accelerates recognition of a plan’s unrecognized net gain or loss, is triggered if the lump sums paid during a year exceeds the sum of the plan’s service and interest cost. Since the lump sums paid or expected to be paid in 2016 exceed that threshold, the company recognized a settlement charge of $4.6 million in the second quarter. The company recognized a settlement charge of $1.8 million in the third quarter.  An additional settlement charge may be recognized in the fourth quarter. The amount of the charge will depend on the amount settled and the plan’s unrecognized net gain or loss at the end of the fourth quarter.

The company used a measurement date of December 31, 2015 for the defined benefit and post-retirement benefit plans described below (excluding Plan No. 1 which has a measurement date of September 30, 2016 due to the settlement). We believe that the difference in the fair value of plan assets between the measurement date of December 31, 2015 and our fiscal year end date of January 2, 2016 was not material and that for practical purposes the measurement date of December 31, 2015 was used throughout for preparation of our financial statements.  The increase in the actuarial loss from January 2, 2016 to October 8, 2016 is primarily due to a decrease in the discount rate used to measure the obligation at the time of re-measurement, which resulted in an increase to the noncurrent benefit liability above.  

The company voluntarily contributed $1.0 million to our qualified pension plans during our third quarter.  We do not anticipate making additional contributions to our qualified pension plans during the remainder of fiscal 2016.

The net periodic pension cost (income) for the company’s plans include the following components (amounts in thousands):

 

 

Post-retirement Benefit Plan

The company provides certain medical and life insurance benefits for eligible retired employees covered under the active medical plans. The plan incorporates an up-front deductible, coinsurance payments and retiree contributions at various premium levels. Eligibility and maximum period of coverage is based on age and length of service.

The net periodic post-retirement benefit (income) cost for the company includes the following components (amounts in thousands):  

 

 

401(k) Retirement Savings Plan

The Flowers Foods 401(k) Retirement Savings Plan covers substantially all of the company’s employees who have completed certain service requirements. During the forty weeks ended October 8, 2016 and October 10, 2015, the total cost and employer contributions were $22.3 million and $20.5 million, respectively.  During the twelve weeks ended October 8, 2016 and October 10, 2015, the total cost and employer contributions were $6.5 million and $6.0 million, respectively.

The company acquired DKB and Alpine during fiscal 2015, at the time of each acquisition we assumed sponsorship of a 401(k) savings plan.  We merged these two plans into the Flowers Foods 401(k) Retirement Savings Plan during the forty weeks ended October 8, 2016.

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15. INCOME TAXES

The company’s effective tax rate for the forty weeks ended October 8, 2016 and October 10, 2015 was 35.1% and 35.4%, respectively.  The decrease in the rate is primarily related to certain nondeductible acquisition-related costs recognized in the prior year and an increase in the qualifying domestic production activities deduction (“Section 199”).  The most significant differences in the effective rate and the federal statutory rate are additions for state income taxes, offset by reductions for Section 199.

During the forty weeks ended October 8, 2016, the company’s activity with respect to its uncertain tax positions and related interest expense accrual was immaterial. At this time, we do not anticipate significant changes to the amount of gross unrecognized tax benefits over the next twelve months.

The company early adopted guidance discussed in Note 3, Recently Adopted Accounting Pronouncements, and retrospectively adjusted our current deferred income tax asset balance of $37.2 million at January 2, 2016 to the long-term deferred income tax liability balance.  The Condensed Consolidated Balance Sheet at October 8, 2016 reflects this change.

The Internal Revenue Service (“IRS”) completed the audit of fiscal years 2012, 2013, and 2014 during the first quarter of our fiscal 2016.  The results of the audit were insignificant and the company is no longer subject to federal examination for years prior to 2015 and, with limited exceptions, for years prior to 2012 in state jurisdictions.

16. SEGMENT REPORTING

The company’s DSD Segment primarily produces fresh packaged bread, rolls, tortillas, and snack products and the Warehouse Segment produces fresh and frozen bread and rolls and snack products.

The company evaluates each segment’s performance based on income or loss before interest and income taxes, excluding unallocated expenses and charges which the company’s management deems to be an overall corporate cost or a cost not reflective of the segment’s core operating businesses. Information regarding the operations in these reportable segments is as follows (amounts in thousands):

 

 

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Sales by product category in each reportable segment are as follows for the twelve and forty weeks ended October 8, 2016 and October 10, 2015 (amounts in thousands):

 

 

 

17. ASSETS HELD FOR SALE

The company purchases distribution rights from and sells distribution rights to independent distributors from time to time. The company repurchases distribution rights from independent distributors in circumstances when the company decides to exit a territory or, in some cases, when the independent distributor elects to terminate the relationship with the company. In the majority of the Distributor Agreements, if the company decides to exit a territory or stop using the independent distribution model in a territory, the company is contractually required to purchase the distribution rights from the independent distributor. In the event an independent distributor terminates his or her relationship with the company, the company, although not legally obligated, may repurchase and operate those distribution rights as a company-owned territory. The independent distributors may also sell their distribution rights to another person or entity. Distribution rights purchased from independent distributors and operated as company-owned territories are recorded on the company’s Condensed Consolidated Balance Sheet in the line item “Assets Held for Sale” while the company actively seeks another independent distributor to purchase the distribution rights for the territory.

Distributions rights held for sale and operated by the company are sold to independent distributors at fair market value pursuant to the terms of a Distributor Agreement. There are multiple versions of the Distributor Agreement in place at any given time and the terms of such Distributor Agreements vary.  When this occurs, the company records a liability for this amount during the six-month period. If the independent distributor’s truck is leased, the company will assume the lease payment (but not the lease) until such time as the distribution rights are sold to a new purchaser or until the expiration of the six month period, whichever comes first. Under a majority of Distributor Agreements, should the independent distributor wish to sell the distribution rights after the six-month period has expired, the company has a right of first refusal but is not required to purchase the distribution rights. After the six-month period expires, if the distribution rights have not sold and the business is still being operated by the company, a liability is recorded as deferred income and will be recognized over the term of the distribution rights’ note receivable.

The company is also selling certain plants and depots that it acquired in July 2013 from Hostess Brands, Inc., which initially included 20 closed plants and 36 depots (the “Acquired Hostess Bread Assets”). The Acquired Hostess Bread Assets were originally recorded as held and used. Subsequent to the acquisition of the Acquired Hostess Bread Assets, we determined that some of the acquired plants and depots do not meet our long-term operating strategy, and we are actively marketing them for sale. Since the acquisition, the company has sold ten plants and 19 depots through October 8, 2016.  Three of the plants have been opened, four of the plants are currently reported as held for sale (and are being actively marketed for sale) and three of the plants are under review for future use.  We continually review the Acquired Hostess Bread Assets and during our third quarter of fiscal 2016 we decided to market an additional plant as held for sale.  There are certain other properties not associated with the Acquired Hostess Bread Assets that are also in the process of being sold. These assets are recorded on the Condensed Consolidated Balance Sheet in the line item “Assets Held for Sale” and are included in the “Other” line item in the summary table below.

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Additional assets recorded in assets held for sale are for property, plant and equipment, exclusive of the assets acquired as part of the Acquired Hostess Bread Assets discussed above. The carrying values of assets held for sale are not amortized and are evaluated for impairment as required at the end of the reporting period. The table below presents the assets held for sale as of October 8, 2016 and January 2, 2016, respectively (amounts in thousands):  

 

 

 

18. ACCELERATED SHARE REPURCHASE PROGRAM

On March 16, 2016, the company announced that we entered into an accelerated share repurchase program (“ASR”) agreement to repurchase an aggregate of $120.0 million of the company’s common stock.  Under the terms of the ASR, the company paid $120.0 million in cash and received an initial delivery of 5.6 million shares immediately.  The final number of shares repurchased was based on the daily volume-weighted average stock price over the life of the transaction, less a negotiated discount.  During the second quarter of fiscal 2016, a total of 0.9 million shares were issued to the company at the time of final settlement.  The ASR met all applicable criteria for equity classification and, therefore, was not accounted for as a derivative instrument.  Shares repurchased under the ASR were added to our treasury shares.  The company funded the ASR with borrowings on its credit facility and cash on hand.

During the forty weeks ended October 8, 2016, 6.9 million shares, at a cost of $126.3 million, of the company’s common stock were repurchased (and settled) under an authorized share repurchase plan and the ASR.  From the inception of the plan through October 8, 2016, 67.8 million shares, at a cost of $630.4 million, have been repurchased.

19. SUBSEQUENT EVENTS

The company has evaluated subsequent events since October 8, 2016, the date of these financial statements. We believe there were no material events or transactions discovered during this evaluation that requires recognition or disclosure in the financial statements other than the item discussed below.

On November 8, 2016, the company reached an agreement to settle a class-action lawsuit.  See Note 11, Litigation, for additional information.

 

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of the financial condition and results of operations of the company as of and for the twelve and forty weeks ended October 8, 2016 should be read in conjunction with the company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2016 (the “Form 10-K”).

OVERVIEW:

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is segregated into four sections, including:

There were several significant events that will provide additional context while reading this discussion. These events include:

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Business

Flowers is focused on opportunities for growth within the baked foods category and seeks to have its products available wherever baked foods are purchased or consumed — whether in retail or foodservice channels.  The company currently has 49 operating plants in 18 states that produce a wide range of breads, buns, rolls, snack cakes and tortillas.

Segments and delivery methods

The company has two business segments that reflect its two distinct methods of delivering products to market. The DSD Segment products are delivered fresh to customers through a network of independent distributors who are incentivized to grow sales and to build equity in their distributorships.  The DSD Segment currently has access to more than 85% of the U.S. population for fresh bakery foods. The warehouse delivery segment (the “Warehouse Segment”) ships fresh and frozen products to customers’ warehouses nationwide.  Customers then distribute these products to their depots, stores, or restaurants.  Flowers’ plants fall into either the DSD Segment or Warehouse Segment depending on the primary method of delivery used to sell their products.

The DSD Segment operates a highly involved system of reciprocal baking whereby each plant has an assigned production mission to produce certain items for its own market as well as for other DSD Segment plants’ markets and the Warehouse Segment. This system allows for long and efficient production runs that help the company maintain its position as a low-cost producer. Plants within regional networks exchange products overnight through a third-party transportation system so that at the beginning of each sales day every DSD Segment plant has a full complement of fresh products for its independent distributors to provide to their retail and foodservice customers.

The company has invested significant capital in its plants for several decades to ensure its production is as efficient as possible, uses technology effectively, provides consistent excellent product quality, and offers a good working environment for team members. During the forty weeks ended October 8, 2016, we had capital expenditures of $67.4 million.  

Consumers and our product portfolio

Flowers recognizes the need to stay in touch with changing consumer trends regarding baked foods. As a result, ongoing research on consumer preferences is conducted and external resources are engaged to help ensure our bakery products remain on trend with consumers’ changing taste, texture, and flavor trends. Our marketing, quality assurance, and research and development teams collaborate regularly as new products are considered, developed, tested, and introduced.

Brands are important in the bakery category and the company has invested over several decades in its brand portfolio through advertising, promotion, and packaging. Nature’s Own, introduced in 1977, was developed to address the developing trend of consumers demanding baked foods with a healthier profile. Nature’s Own, from inception, has offered baked foods with no artificial flavors, colors, or preservatives.

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On October 13, 2015, we completed the acquisition of Alpine and their product line of certified organic breads, as well as other bakery products.  These products, which are warehouse delivered, are marketed under the Alpine Valley Bread brand and expand our penetration into the organic market and provide additional organic production capacity.

On September 12, 2015, we completed the DKB acquisition, which includes a full product line of super premium whole-grain 100% organic and non-GMO bakery products sold under the DKB label, the leading organic bread brand in the U.S.  During the second quarter of fiscal 2016, we began the national rollout of the DKB brand on our DSD network.  The rollout is complete as we have introduced the DKB products throughout our DSD geographic footprint.

On July 19, 2013, we completed the acquisition of the Acquired Hostess Bread Assets which included the Wonder, Home Pride, Merita and Butternut bread brands, 20 closed plants and 36 depots.  These bread brands were taken off the market when Hostess Brands, Inc. ceased operations in November 2012.  Late in the third quarter of fiscal 2013, we began reintroducing these brands to the marketplace within our DSD Segment.  We are continuing to reintroduce these brands as we expand into new markets.  

Snack cakes have been part of the company’s product offerings since at least the early 1920s. In more recent years, snack cakes have been developed and introduced primarily under the Mrs. Freshley’s brand for our Warehouse Segment.  In 2011, the company acquired Tasty Baking Co. (“Tasty”) and its extensive line of Tastykake branded snack cakes.  Since the acquisition of Tasty, we have expanded the distribution and the product line of Tastykake products throughout the territories in our DSD Segment.

Strengths and core competencies

We aim to achieve consistent and sustainable growth in sales and earnings by focusing on improvements in the operating results of our existing plants and, after detailed analysis, acquiring companies and properties that add value to the company. We believe this strategy has resulted in consistent and sustainable growth that will continue to build value for our shareholders.

The company also is committed to maintaining a collaborative, in-house information technology team, as well as certain outsourced services, that meets all of our plants’ needs and maximizes efficiencies. The consumer packaged goods industry has used scan-based trading technology (referred to as “pay by scan” or “PBS”) over several years to share information between the supplier and retailer. An extension of this technology allows the retailer to pay the supplier when the consumer purchases the goods rather than at the time they are delivered to the retailer. In addition, PBS permits the capture of information to more accurately track trends in product sales and manage inventory.

We regularly articulate our core business strategies to the investment community and internally to our team members, including long-term (five-year) goals. Compensation and bonus programs are linked to the company’s short and long-term goals. The majority of our employees participate in an annual formula-driven, performance-based cash bonus program. In addition, certain employees participate in a long-term incentive program that provides performance-contingent common stock awards that generally vest over a two-year period. We believe these incentive programs provide both a short and long-term goal for our most senior management team and aligns their interests with those of our shareholders.

We believe our highly automated plants, with teams that focus on quality, bake products that meet consumers’ needs. We strive to maintain and exceed service levels for our customers, consumers, and suppliers. The design of our delivery systems and segments permits us to allocate management time and resources to meet marketplace expectations.

Competition and risks

Hostess’ liquidation in late November 2012 impacted the industry as Hostess sales shifted to other providers to meet marketplace needs. These providers included Flowers, Grupo Bimbo (with Sara Lee, Arnolds, Thomas, and Entenmann’s brands), Campbell Soup Company (with the Pepperidge Farm brand), McKee Foods Corporation (Little Debbie) and smaller regional bakeries, retailer-owned bakeries, and store brands. Certain Hostess cake products were re-introduced into the market in July 2013 by a new and separate company, Hostess Brands, LLC (“Hostess LLC”), formed by the outside investment group of Apollo Global Management and C. Dean Metropoulous & Co. that purchased the Hostess cake brands.

Sales are principally affected by pricing, quality, brand recognition, new product introductions, product line extensions, marketing, and service. Sales for the twelve weeks ended October 8, 2016 increased 3.8% as compared to the same period in the prior year. This increase was due to both the DKB and Alpine acquisition contribution, partially offset by decreased volume in non-acquisition related sales.

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Commodities, such as our baking ingredients, periodically experience price fluctuations. The cost of these inputs may fluctuate widely due to government policy and regulation, weather conditions, domestic and international demand, or other unforeseen circumstances. We enter into forward purchase agreements and other derivative financial instruments in an effort to manage the impact of such volatility in raw material prices. Any decrease in the availability of these agreements and instruments could increase the effective price of these raw materials to us and significantly affect our earnings.

Valuation of Indefinite-Lived Intangible Assets

The company evaluates the recoverability of our indefinite-lived intangible assets that are not subject to amortization by comparing the fair value to the carrying value on an annual basis or at a time when events occur that indicate the carrying value may be impaired.  In addition, the assets are evaluated to determine whether events and circumstances continue to support an indefinite life.  The fair value is compared to the carrying value of the intangible asset, and if less than the carrying value, the intangible asset is written down to fair value.  There are certain inherent risks included in our expectations about the performance of acquired trademarks and brands. If we are unable to implement our growth strategies for these acquired intangible assets as expected, it could adversely impact the carrying value of the brands. The implied fair value of the trademarks could be less than our carrying value under Step 1 of our impairment analysis if any of our four material assumptions in our fair value analysis do not meet our expectations: (a) weighted average cost of capital; (b) long-term sales growth rates; (c) forecasted operating margins; and (d) market multiples. We are continually monitoring our trademarks. Based on management’s evaluation, no impairment charges relating to intangible assets were recorded during the forty weeks ended October 8, 2016.

The impairment analysis on the indefinite-lived intangible asset trademarks is sensitive to the long-term growth rates of the trademarks. The company also continually analyzes our expansion markets to determine in which markets our trademarks may be introduced. If the timing of our expansion does not proceed as we currently anticipate or if the anticipated revenues do not meet our expectations, these trademarks could become impaired in future periods.  

CRITICAL ACCOUNTING POLICIES:

Our financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). These principles are numerous and complex. Our significant accounting policies are summarized in the company’s Form 10-K. In many instances, the application of GAAP requires management to make estimates or to apply subjective principles to particular facts and circumstances. A variance in the estimates used or a variance in the application or interpretation of GAAP could yield a materially different accounting result. Please see our Form 10-K, for a discussion of the areas where we believe that the estimates, judgments or interpretations that we have made, if different, could yield the most significant differences in our financial statements. There have been no significant changes to our critical accounting policies from those disclosed in the Form 10-K.

See Note 3, Recently Adopted Accounting Pronouncements, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q for information regarding recently adopted accounting pronouncements.

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RESULTS OF OPERATIONS:

Results of operations, expressed as a percentage of sales and the dollar and percentage change from period to period, for the twelve weeks ended October 8, 2016 and October 10, 2015, are set forth below (dollars in thousands):

 

 

Percentages may not add due to rounding.

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Results of operations, expressed as a percentage of sales and the dollar and percentage change from period to period, for the forty weeks ended October 8, 2016 and October 10, 2015, are set forth below (dollars in thousands):

 

 

Percentages may not add due to rounding.

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CONSOLIDATED AND SEGMENT RESULTS

TWELVE WEEKS ENDED OCTOBER 8, 2016 COMPARED TO TWELVE WEEKS ENDED OCTOBER 10, 2015

Consolidated Sales.

 

 

The change in sales was generally attributable to the following:

 

 

Sales category discussion

The DKB and Alpine acquisitions drove the overall increase in sales, partially offset by softer volume for other branded retail products due to a highly competitive marketplace.  Growth in branded organic sales due to the DKB and Alpine acquisitions, and to a lesser extent positive price/mix in the branded retail category, resulted in the significant increase in sales in that category, partially offset by declines most notably in branded soft variety and branded cake.  Sales of the DKB brand are continuing to grow in both our core and expansion markets due to the national rollout, which began in the second quarter of fiscal 2016, as well as increased marketing efforts.  The increase in store branded retail sales was mostly attributable to increases in sales of store branded variety bread partially offset by declines in store branded cake due to volume declines.  

DSD Segment Sales.

 

 

The change in sales was generally due to the following:

 

 

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Sales category discussion

The DSD Segment sales increase was due to the DKB acquisition contribution and positive price/mix, partially offset by softer volume for other branded retail items.  Excluding acquisition sales until the first anniversary of the acquisition date, volumes were negatively impacted by a highly competitive marketplace, partially offset by growth in branded organic bread resulting from the national rollout of the DKB brand beginning in the second quarter of fiscal 2016.  The overall increase in branded retail sales was due to the acquisition and the national rollout of the DKB brand, partially offset by declines in most other branded retail items, of which branded soft variety bread and branded cake experienced the largest declines.  Store branded retail sales increased primarily due to volume gains in store branded variety bread.  Non-retail and other sales decreased primarily due to volume declines in foodservice and institutional sales, partially offset by positive pricing/mix.

Warehouse Segment Sales.

 

 

The change in sales was generally attributable to the following:

 

 

Sales category discussion

Overall, the significant sales increase in the Warehouse Segment was due to the Alpine acquisition sales and to a lesser extent, volume growth in the non-retail and other category.  Excluding the Alpine acquisition, negative pricing/mix in the non-retail and other category was partially offset by positive price/mix in the branded retail category.  The increase in branded retail sales was due to the Alpine acquisition contribution and to a lesser extent increased bakery deli sales.  Store branded retail sales decreased mainly due to volume decreases in store branded cake.  The increase in non-retail and other sales, which include contract manufacturing, vending and foodservice, was due primarily to volume increases in foodservice sales, driven by new foodservice products for certain of our customers, and increases in contract manufacturing, partially offset by negative price/mix.

Materials, Supplies, Labor and Other Production Costs (exclusive of depreciation and amortization shown separately). The table below presents the significant components of materials, supplies, labor and other production costs (exclusive of depreciation and amortization shown separately) as a percent of sales:

 

 

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Ingredient costs decreased as a percent of sales primarily due to lower prices for non-organic flour and oils and significantly lower egg prices, partially offset by increased purchases of higher priced organic ingredients and higher sweetener prices.  As anticipated, outside purchases of product have begun to moderate due to the additional organic production capacity provided by our Tuscaloosa, Alabama plant which began producing organic bread at the beginning of the second quarter of fiscal 2016.  Additionally, the Warehouse Segment’s Alpine facility produces certain DKB products for the DSD Segment.  Workforce-related costs increased as a percent of sales mostly due to wage increases on softer non-acquisition related sales.  

The table below presents the significant components of materials, supplies, labor and other production costs for the DSD Segment (exclusive of depreciation and amortization shown separately) as a percent of sales:

 

 

Ingredient costs decreased as a percent of sales primarily due to lower prices for non-organic flour, eggs and oils and increases in product purchases from the Warehouse Segment (sales with no associated ingredient costs), partially offset by increased purchases of higher priced organic ingredients.  Workforce-related costs increased as a percent of sales principally due to wage increases on softer non-acquisition related sales, partially offset by increased purchases from the Warehouse Segment (sales with no associated workforce-related costs).  Packaging costs as a percent of sales decreased primarily due to lower resin prices.  As anticipated, outside purchases of DKB products have decreased due to the added production capacity of the Tuscaloosa, Alabama plant as well as the Alpine facility in the Warehouse Segment.

The table below presents the significant components of materials, supplies, labor and other production costs for the Warehouse Segment (exclusive of depreciation and amortization shown separately) as a percent of sales:

 

 

Overall, lower costs for Alpine as a percent of the Warehouse Segment sales largely drove the decrease.  Ingredient costs increased slightly as a percent of sales primarily due to increased purchases of higher priced organic ingredients, higher prices for sweeteners and increased sales to the DSD Segment (ingredient costs with no associated sales), partially offset by significantly lower egg prices and lower prices for non-organic flour.  Workforce-related costs increased as a percent of sales due to increased sales of product to the DSD Segment (workforce-related costs with no associated sales) and the addition of a production line at one of our existing facilities.  Packaging costs decreased as a percent of sales primarily due to a shift in mix from cake to bread items which carry a lower packaging cost and lower paperboard and resin prices.  The other line item mostly reflects the increase in intercompany sales of product to the DSD Segment.

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Selling, Distribution and Administrative Expenses. The table below presents the significant components of selling, distribution and administrative expenses as a percent of sales:

 

 

The increase in workforce-related costs as a percent of sales was primarily due to a smaller percentage of our sales being sold via independent distributors in the current quarter as compared to the prior year quarter.  Distributor distribution fees decreased as a percent of sales due to the item discussed above.  Higher marketing and legal expenses drove the increase in the other line item component, partially offset by prior year acquisition-related costs of $5.0 million.  Marketing expenses increased as a percent of sales primarily due to promoting the DKB and Alpine brands.  Legal costs increased mainly due to the on-going distributor lawsuits and a $1.25 million legal settlement recorded in the current quarter.  See Note 11, Litigation, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q for additional information.  As discussed in the “Overview” section above, the company incurred consulting costs associated with Project Centennial, an enterprise-wide business and operational review.  Prior year consulting costs mostly offset the current year costs. We anticipate continued consulting costs related to the project in subsequent quarters.    

The table below presents the significant components of our DSD Segment selling, distribution and administrative expenses as a percent of sales:

 

 

Workforce-related costs increased as a percentage of sales due to a smaller portion of our sales being sold via independent distributors in the current quarter as compared to the prior year quarter which resulted in decreased distributor distribution fees.  Softer non-acquisition related sales also contributed to the increased workforce-related costs as a percent of sales.  The increase in the other line item as a percentage of sales was driven by higher legal costs related to the distributor lawsuits and a $1.25 million legal settlement as discussed above, increased marketing costs due to promoting the DKB brand and increased corporate overhead charges to the DSD Segment.  

The table below presents the significant components of our Warehouse Segment selling, distribution and administrative expenses as a percent of sales:

 

 

The increase in the other line item was mostly attributable to higher promotional spending related to the Alpine brand.  

Pension Plan Settlement Loss. We recorded a settlement charge of $1.8 million during the twelve weeks ended October 8, 2016.  Refer to the pension risk mitigation plan discussed in the “Overview” section above for additional details.

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Depreciation and Amortization. Depreciation and amortization expense increased primarily due to higher amortization expense related to the DKB (included in the DSD Segment) and Alpine (included in the Warehouse Segment) intangible assets which were acquired in the third and fourth quarter of fiscal 2015, respectively.

Income from Operations. The table below summarizes the percentage change in income from operations by segment for the twelve weeks ended October 8, 2016 compared to the twelve weeks ended October 10, 2015:

 

 

The decrease in the DSD Segment operating income as a percent of sales was primarily driven by higher selling, distribution and administrative expenses as a percent of sales discussed above, partially offset by lower ingredient costs.  The Warehouse Segment operating income as a percent of sales was consistent with prior year.  The favorable change in unallocated corporate expenses was primarily due to increased overhead charges to the segments in the current year quarter and the $5.0 million of acquisition-related costs incurred in the prior year quarter, partially offset by the $1.8 million pension plan settlement loss in the current year quarter.  In the prior year quarter, unanticipated legal costs were not allocated to the segments, but instead were absorbed at the corporate level.

Net Interest Expense. The increase was due to expensing debt issuance costs of $1.9 million associated with our existing term loan facilities that were paid off with proceeds from the issuance of the 2026 notes.  Additionally, higher average amounts outstanding under the company’s debt arrangements resulted in increased interest expense.  We borrowed under our credit facilities in the second half of fiscal 2015 to fund the DKB and Alpine acquisitions, as well as in the first quarter of fiscal 2016 for the ASR.

Income Taxes. The effective tax rate for the twelve weeks ended October 8, 2016 was 34.6% compared to 36.4% in the prior year quarter.  The decrease in the rate was primarily due to certain non-deductible acquisition-related costs recognized in the prior year quarter and an increase in the qualifying domestic production activities deduction (Section 199) in the current year quarter.  The adjustment to the year to date tax expense to reflect a lower annualized effective tax rate also decreased income tax expense for the current quarter.  The most significant differences in the effective rate and the statutory rate were related to state income taxes, partially offset by reductions for the qualifying domestic production activities deduction.

 

FORTY WEEKS ENDED OCTOBER 8, 2016 COMPARED TO FORTY WEEKS ENDED OCTOBER 10, 2015

Consolidated Sales.

 

 

The change in sales was generally attributable to the following:

 

 

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Sales category discussion

Sales from the DKB and Alpine acquisitions resulted in the overall sales increase.  Price/mix declines were mostly attributable to the non-retail and other category, partially offset by positive price/mix in the branded retail category.  Branded retail sales grew due to the DKB and Alpine acquisitions contribution and positive price/mix.  Partially offsetting the increase was softer sales in other branded retail products, most significantly branded soft variety bread, due to reductions in promotional activities and a competitive marketplace.  The increase in store branded retail sales was mostly attributable to increases in sales of store branded cake and variety bread.  The modest increase in non-retail and other sales, which include contract manufacturing, vending and foodservice, was mainly due to increases in foodservice and vending, mostly offset by decreases in price/mix.

DSD Segment Sales.

 

 

The change in sales was generally due to the following:

 

 

Sales category discussion

The DKB acquisition sales contribution and positive price/mix resulted in the DSD Segment sales increase, partially offset by volume declines, largely in other branded retail products.  Excluding acquisition sales until the first anniversary of the acquisition date, volumes were negatively impacted by decreased promotional activity and a competitive marketplace, partially offset by growth in branded organic bread from the national rollout of the DKB brand.  The increase in branded retail sales was due to the DKB acquisition and positive price/mix, partially offset by decreases in most other branded retail products, with the largest decline in branded soft variety bread.  The modest decrease in non-retail and other sales was mainly attributable to a decrease in institutional sales, partially offset by increased foodservice sales.  

Warehouse Segment Sales.

 

 

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The change in sales was generally attributable to the following:

 

 

Sales category discussion

Sales in the Warehouse Segment increased significantly due to the Alpine acquisition and to a lesser extent, volume growth in the non-retail and other and store branded retail categories, partially offset by negative pricing/mix.  Lower foodservice pricing largely drove the decrease in price/mix.  Branded retail sales increased due to the Alpine acquisition and less significantly to growth in bakery deli sales, partially offset by declines in branded cake.  Store branded retail sales increased due to increases in store branded cake.  The increase in non-retail and other sales, which include contract manufacturing, vending and foodservice, was mostly due to increases in foodservice sales, driven by new foodservice products for certain of our customers, and in vending, partially offset by negative price/mix.

Materials, Supplies, Labor and Other Production Costs (exclusive of depreciation and amortization shown separately). The table below presents the significant components of materials, supplies, labor and other production costs (exclusive of depreciation and amortization shown separately) as a percent of sales:

 

 

Ingredient costs decreased as a percent of sales primarily due to lower prices for non-organic flour, oils and eggs and increases in outside purchases of product (sales with no associated ingredient costs), partially offset by increased purchases of higher priced organic ingredients and increases in sweetener prices.  The increase in the outside purchased products is reflected in the other line item above and mostly relates to outside purchases for certain of the DKB products due to capacity constraints and to a much lesser extent increased outside purchases for other products.  As anticipated, outside purchases of product have begun to moderate with the additional organic production capacity provided by our Tuscaloosa, Alabama plant which began producing organic bread at the beginning of the second quarter of fiscal 2016, and the Alpine plant.  Workforce-related costs increased as a percent of sales due to wage increases on softer non-acquisition related sales and costs associated with the organic plant conversion, partially offset by increased outside purchases of product (sales with no associated workforce-related costs).  Packaging costs were lower as a percent of sales mainly due to lower resin prices and a shift in mix from cake to bread items.  

The table below presents the significant components of materials, supplies, labor and other production costs for the DSD Segment (exclusive of depreciation and amortization shown separately) as a percent of sales:

 

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Ingredient costs decreased as a percent of sales largely due to lower prices for non-organic flour and oils and increases in outside purchases of product and purchases from the Warehouse Segment (sales with no associated ingredient costs), partially offset by higher prices for the organic ingredients.  The increase in workforce-related costs as a percent of sales was primarily due to wage increases on non-acquisition related sales and costs related to converting the Tuscaloosa, Alabama plant to an organic facility, partially offset by increased outside and intercompany purchases of product (sales with no associated workforce-related costs).  The increase in the other line item was due mostly to increases in outside purchases of product and purchases from the Warehouse Segment, largely certain DKB products.  As anticipated, outside purchases of DKB products has begun to moderate with the added production capacity of the Tuscaloosa, Alabama plant and the Alpine facility in the Warehouse Segment.

The table below presents the significant components of materials, supplies, labor and other production costs for the Warehouse Segment (exclusive of depreciation and amortization shown separately) as a percent of sales:

 

 

Ingredient costs were consistent with the prior year as a percent of sales; higher costs for organic ingredients, price increases for sweeteners and increased sales of product to the DSD Segment (ingredient costs with no associated sales) were offset by lower prices for non-organic flour, eggs and oil and increases in outside purchases of product (sales with no associated ingredient costs).  Packaging costs decreased as a percent of sales primarily due to significantly lower packaging costs for Alpine products compared to the overall Warehouse Segment and a shift in mix from cake to bread items.  The other line item reflects the increased intercompany sales of product to the DSD Segment mostly offset by the increase in outside purchases of product.

Selling, Distribution and Administrative Expenses. The table below presents the significant components of selling, distribution and administrative expenses as a percent of sales:

 

 

The increase in workforce-related costs as a percent of sales was primarily due to a smaller portion of our sales being sold via independent distributors in the current year as compared to the prior year and softer non-acquisition related sales.  Lower employee incentive costs as a percent of sales partially offset the increase.  The distributor distribution fees decrease resulted from the items discussed above.  Higher marketing costs related to promoting the DKB and Alpine brands as well as higher legal and consulting costs drove the increase in the other line item component, partially offset by prior year acquisition-related costs of $5.0 million. Legal costs increased primarily due to the on-going distributor lawsuits and a $1.25 million settlement recorded in the current year.  See Note 11, Litigation, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q for additional information.  As discussed in the “Overview” section above, we incurred consulting costs associated with Project Centennial, an enterprise-wide business and operational review, and we expect these costs to continue in subsequent quarters.

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The table below presents the significant components of our DSD Segment selling, distribution and administrative expenses as a percent of sales:

 

 

Workforce-related costs increased as a percentage of sales due to a smaller portion of our sales being sold via independent distributors in the current year as compared to the prior year and softer non-acquisition related sales.  Lower employee incentive costs partially offset the increase.  The decrease in distributor distribution fees correlates with the increase in workforce-related costs as a percent of sales.  The increase in the other line item as a percentage of sales was driven by higher legal costs related to the distributor lawsuits and a $1.25 million settlement as discussed above, increased corporate overhead charges to the DSD Segment, and higher marketing expense largely related to the DKB brand.

The table below presents the significant components of our Warehouse Segment selling, distribution and administrative expenses as a percent of sales:

 

 

The increase in the other line item was mostly attributable to higher promotional spending for the Alpine brand.  

Depreciation and Amortization. Depreciation and amortization expense increased primarily due to higher amortization expense related to the DKB (included in the DSD Segment) and Alpine (included in the Warehouse Segment) intangible assets which were acquired in the third and fourth quarter of fiscal 2015, respectively.

Pension Plan Settlement Loss. We recorded settlement charges of $6.5 million during the forty weeks ended October 8, 2016.  Refer to the pension risk mitigation plan discussed in the “Overview” section above for additional details.

Impairment of Assets. During the prior year, we recorded asset impairments of $0.8 million related to certain DSD Segment properties held for sale and $1.5 million related to a production line at one of our DSD Segment plants that we no longer use.

Income from Operations. The table below summarizes the percentage change in income from operations by segment for the forty weeks ended October 8, 2016 compared to the forty weeks ended October 10, 2015:

 

 

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The decrease in the DSD Segment operating income as a percent of sales was primarily driven by higher selling, distribution and administrative expenses discussed above.  The Warehouse Segment operating income as a percent of sales was relatively consistent with prior year.  The favorable change in unallocated corporate expenses was primarily due to increased overhead charges to the segments in the current year and $5.0 million of acquisition-related costs incurred in the prior year, partially offset by the $6.5 million pension plan settlement loss in the current year.  In the prior year, unanticipated legal costs were not allocated to the segments, but instead were absorbed at the corporate level.

Net Interest Expense.  The increase was due to expensing debt issuance costs of $1.9 million associated with our existing term loan facilities that were paid off with proceeds from the issuance of the 2026 notes. Additionally, higher average amounts outstanding under the company’s debt arrangements increased interest expense and to a lesser extent decreases in distributor notes receivables outstanding reduced interest income.  We drew down on our credit facilities in the second half of fiscal 2015 to fund the DKB and Alpine acquisitions, as well as in the first quarter of fiscal 2016 for the ASR.

Income Taxes. The effective tax rate for the forty weeks ended October 8, 2016 was 35.1% compared to 35.4% in the prior year. The decrease in the rate was primarily related to certain nondeductible acquisition-related costs recognized in the prior year and an increase in the qualifying domestic production activities deduction (Section 199) in the current year.  The most significant differences in the effective rate and the statutory rate were related to state income taxes, partially offset by reductions for the qualifying domestic production activities deduction.

LIQUIDITY AND CAPITAL RESOURCES:

Liquidity represents our ability to generate sufficient cash flows from operating activities to meet our obligations and commitments as well as our ability to obtain appropriate financing and convert into cash those assets that are no longer required to meet existing strategic and financing objectives. Therefore, liquidity cannot be considered separately from capital resources that consist primarily of current and potentially available funds for use in achieving long-range business objectives. Currently, the company’s liquidity needs arise primarily from working capital requirements, capital expenditures, pension contributions and obligated debt payments. The company’s strategy for use of its cash flow includes paying dividends to shareholders, making acquisitions, growing internally and repurchasing shares of its common stock, when appropriate. We believe we have access to available funds to meet our short and long-term capital requirements.

The company leases certain property and equipment under various operating and capital lease arrangements. Most of the operating leases provide the company with the option, after the initial lease term, either to purchase the property at the then fair value or renew its lease at the then fair value. The capital leases provide the company with the option to purchase the property at a fixed price at the end of the lease term. The company believes the use of leases as a financing alternative places the company in a more favorable position to fulfill its long-term strategy for the use of its cash flow. See Note 12, Debt, Lease and Other Commitments, of Notes to Consolidated Financial Statements of our Form 10-K for detailed financial information regarding the company’s lease arrangements.

Liquidity discussion for the forty weeks ended October 8, 2016 and October 10, 2015

Cash and cash equivalents were $7.5 million at October 8, 2016 as compared to $14.4 million at January 2, 2016. The cash and cash equivalents were derived from the activities presented in the table below (amounts in thousands):

 

 

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Cash Flows Provided by Operating Activities. Net cash provided by operating activities consisted of the following items for non-cash adjustments to net income (amounts in thousands):

 

 

Net changes in working capital and pension contributions consisted of the following items (amounts in thousands):

 

 

Other non-cash items include non-cash interest expense for the amortization of debt discounts and deferred financing costs, the tax shortfall at vesting of performance-contingent restricted stock awards and gains or losses on the sale of assets.  The change in deferred income taxes primarily relates to a prior period tax benefit associated with pension contributions.  We do not expect to make any contributions to our qualified pension plans in our fourth quarter.  We expect to pay an additional $0.2 million in nonqualified pension benefits from corporate assets during the remainder of fiscal 2016.  The company believes its cash flow and balance sheet will allow it to fund future pension needs without adversely affecting the business strategy of the company.  The change in pension and postretirement plans income was due to the pension plan settlement losses of $6.5 million recorded during the forty weeks ended October 8, 2016.

The change in inventories described above was primarily due to more favorable commodity prices. Hedging activities change from market movements that affect the fair value and required collateral of positions and the timing and recognition of deferred gains or losses. The accrued liabilities changes are from changes in accrued income tax balances, changes in book overdrafts and accrued employee costs (including accrued compensation for our formula driven, performance-based cash bonus program).

The company’s derivative instruments contained no credit-risk-related contingent features at October 8, 2016. As of October 8, 2016 and January 2, 2016, the company had $9.8 million and $20.7 million, respectively, recorded in other current assets representing collateral from or with counterparties for hedged positions.

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Cash Flows Disbursed for Investing Activities. The table below presents net cash disbursed for investing activities for the forty weeks ended October 8, 2016 and October 10, 2015 (amounts in thousands):

 

 

For the forty weeks ended October 8, 2016, capital expenditures for the DSD Segment and Warehouse Segment were $37.9 million and $13.3 million, respectively. The company currently estimates capital expenditures of approximately $90.0 million to $100.0 million on a consolidated basis during fiscal 2016.  Net cash disbursed for investing activities during the forty weeks ended October 10, 2015 included the Roman Meal trademark acquisition of $5.0 million and $280.8 million for the acquisition of DKB.  There were more asset sales from assets currently classified as held for sale during the prior comparable period.

Cash Flows (Disbursed for) Provided by Financing Activities. The table below presents net cash (disbursed for) provided by financing activities for the forty weeks ended October 8, 2016 and October 10, 2015 (amounts in thousands):

 

 

Our dividends paid increased due to an increased dividend payout rate. While there are no requirements to increase the dividend payout, we have shown a recent historical trend to do so. Should this trend continue in the future, we will have additional working capital needs to meet these increased payouts. Stock option exercises and the associated tax windfall benefit decreased due to more exercises in the prior fiscal year as compared to the same period in the current fiscal year. As of October 8, 2016, there were nonqualified stock option grants of 2.6 million shares that were exercisable. These have a remaining contractual life of approximately 0.91 year and a weighted average exercise price of $10.95 per share. At this time, it is expected that these shares will be exercised before the contractual term expires and they may provide an increase to the cash provided by financing activities.

Stock repurchase decisions are made based on our stock price, our belief of relative value, and our cash projections at any given time.  Payments for debt issuance costs and financing fees and the debt discount issued increased because of costs related to the 2026 notes and the 2016 term loan. The change in bank overdraft was a function of our cash receipts at the end of fiscal 2015.  Our cash objective is to minimize cash on hand by using the credit facility. The net debt obligations decreased primarily because we repaid the 2013 and 2016 term loans and made payments on our debt facilities, net of the issuance of the 2026 notes during the third quarter of fiscal 2016.  In the prior year, we borrowed from our facilities to fund the DKB acquisition.  

With the exception of the senior notes, our debt is variable rate debt, as described below.  In periods of rising interest rates the cost of using the facility and credit facility will become more expensive and increase our interest expense.  The stated interest rate of the notes will not change. Therefore, draw downs on the facility and credit facility provide us the greatest direct exposure to rising rates.  In addition, if interest rates do increase it will make the cost of raising funds more expensive. Considering our current debt obligations, an environment of rising rates could affect our Condensed Consolidated Statements of Income.

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Additional liquidity items are discussed below for context.

 

Borrowing Capacity Available under Lines of Credit or Revolving Debt Arrangements

As disclosed in Note 9, Debt and Other Obligations, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q, the company has outstanding debt consisting of our 2022 notes and 2026 notes, accounts receivable securitization facility (the “facility”), and a senior unsecured credit facility (the “credit facility”).  There is no current portion payable over the next year for these obligations.  The facility and credit facility are generally used for short term liquidity needs and are discussed below. The company has historically entered into amendments and extensions approximately one year prior to the maturity of our facility and credit facility.

As of October 8, 2016, $140.0 million was outstanding under the facility compared to $170.0 million outstanding as of January 2, 2016.  On October 8, 2016, the company had $54.2 million available under its facility for working capital and general corporate purposes.  Amounts available for withdrawal under the facility are determined as the lesser of the total commitments and a formula derived amount based on qualifying trade receivables.

At October 8, 2016 and January 2, 2016, there was $10.5 million and $160.0 million, respectively, outstanding under the credit facility.  The highest outstanding daily balance during the forty weeks ended October 8, 2016 was $244.2 million and the lowest outstanding balance was zero.  Amounts outstanding under the credit facility vary daily.  Changes in the gross borrowings and repayments can be caused by cash flow activity from operations, capital expenditures, acquisitions, dividends, share repurchases, and tax payments, as well as derivative transactions which are part of the company’s overall risk management strategy as discussed in Note 8, Derivative Financial Instruments, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q.  During the forty weeks ended October 8, 2016, the company borrowed $1,267.7 million in revolving borrowings under the credit facility and repaid $1,417.2 million in revolving borrowings. The amount available under the credit facility is reduced by $16.3 million for letters of credit.  On October 8, 2016, the company had $473.2 million available under its credit facility for working capital and general corporate purposes.

Restrictive financial covenants for our borrowings can include such ratios as a minimum interest coverage ratio and a maximum leverage ratio. Our debt may also contain certain customary representations and warranties, affirmative and negative covenants, and events of default.  The company believes that, given its current cash position, its cash flow from operating activities and its available credit capacity, it can comply with the current terms of the debt agreements and can meet presently foreseeable financial requirements. As of October 8, 2016 and January 2, 2016, the company was in compliance with all restrictive covenants under our debt agreements.

Uses of Cash

On August 19, 2016, the Board of Directors declared a dividend of $0.16 per share on the company’s common stock that was paid on September 16, 2016 to shareholders of record on September 2, 2016.  The dividend payment was $33.2 million.  On May 26, 2016 the Board of Directors declared a dividend of $0.16 per share on the company’s common stock that was paid on June 23, 2016 to shareholders of record on June 9, 2016.  The dividend payment was $33.2 million.  On February 19, 2016 the Board of Directors declared a dividend of $0.145 per share on the company’s common stock that was paid on March 18, 2016 to shareholders of record on March 4, 2016. The dividend payment was $30.8 million.  Dividends of $0.4 million were paid at the time of vesting of our performance-contingent restricted stock award and at issuance of deferred compensation shares.

Our Board of Directors has approved a plan that authorizes share repurchases of up to 67.5 million shares of the company’s common stock. At the Board of Directors meeting in November 2014, the Board increased the company’s share repurchase authorization by 7.1 million shares to a total of 74.6 million shares. Under the plan, the company may repurchase its common stock in open market or privately negotiated transactions at such times and at such prices as determined to be in the company’s best interest. These purchases may be commenced or suspended without prior notice depending on then-existing business or market conditions and other factors.

In March 2016, the company entered into an ASR agreement with Deutsche Bank AG to repurchase an aggregate of $120.0 million of the company’s common stock under the existing share repurchase program. During the forty weeks ended October 8, 2016, 6.9 million shares, at a cost of $126.3 million, of the company’s common stock were repurchased under the plan.  This included share repurchases under the ASR of 6.5 million shares, at a cost of $120.0 million, and other share repurchases. From the inception of the plan through October 8, 2016, 67.8 million shares, at a cost of $630.4 million, have been repurchased.  

During the first quarter of fiscal 2016, the company paid $25.6 million, including our share of employment taxes and deferred compensation contributions, in performance-based cash awards under the company’s bonus plan.  An additional $0.4 million for our share of employment taxes on the vesting of the performance-contingent restricted stock award were also paid during the first quarter.

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Accounting Pronouncements Recently Adopted

See Note 3, Recently Adopted Accounting Pronouncements, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q for information regarding recently adopted accounting pronouncements.

Accounting Pronouncements Not Yet Adopted

See Note 2, Recent Accounting Pronouncements Not Yet Adopted, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q for information regarding accounting pronouncements not yet adopted.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The company uses derivative financial instruments as part of an overall strategy to manage market risk. The company uses forward, futures, swap and option contracts to hedge existing or future exposure to changes in interest rates and commodity prices. The company does not enter into these derivative financial instruments for trading or speculative purposes. If actual market conditions are less favorable than those anticipated, raw material prices could increase significantly, adversely affecting the margins from the sale of our products.

COMMODITY PRICE RISK

The company enters into commodity forward, futures and option contracts and swap agreements for wheat and, to a lesser extent, other commodities in an effort to provide a predictable and consistent commodity price and thereby reduce the impact of market volatility in its raw material and packaging prices. As of October 8, 2016, the company’s hedge portfolio contained commodity derivatives with a fair value (liability) of $(7.3) million. Of this fair value, $(7.1) million is based on quoted market prices and $(0.2) million is based on models and other valuation methods. Approximately $(0.4) million of this fair value relates to instruments that will be utilized in fiscal 2016 and $(6.9) million that will be utilized in fiscal 2017.

A sensitivity analysis has been prepared to quantify the company’s potential exposure to commodity price risk with respect to the derivative portfolio. Based on the company’s derivative portfolio as of October 8, 2016, a hypothetical ten percent increase (decrease) in commodity prices would increase (decrease) the fair value of the derivative portfolio by $5.5 million. The analysis disregards changes in the exposures inherent in the underlying hedged items; however, the company expects that any increase (decrease) in fair value of the portfolio would be substantially offset by increases (decreases) in raw material and packaging prices.

 

 

ITEM 4. CONTROLS AND PROCEDURES

Management’s Evaluation of Disclosure Controls and Procedures

We have established and maintain a system of disclosure controls and procedures that are designed to ensure that material information relating to the company, which is required to be timely disclosed by us in reports that we file or submit under the Exchange Act, is accumulated and communicated to management in a timely fashion and is recorded, processed, summarized and reported within the time periods specified by the SEC’s rules and forms.

Under the supervision and with the participation of our management, including our Chief Executive Officer (“CEO”), Chief Financial Officer (“CFO”) and Chief Accounting Officer (“CAO”), we conducted an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation and as of the end of the period covered by this report, the CEO, CFO and CAO concluded that the company’s disclosure controls and procedures were effective to allow timely decisions regarding disclosure in its reports that the company files or submits to the SEC under the Exchange Act.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter ended October 8, 2016 that have materially affected or are reasonably likely to materially affect, our internal control over financial reporting.

 

 

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

For a description of all material pending legal proceedings, see Note 11, Litigation, of Notes to Condensed Consolidated Financial Statements of this Form 10-Q.  

ITEM 1A. RISK FACTORS

The information presented below supplements the risk factors set forth in the company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2016 (the “Form 10-K”).  Except as set forth below for additional risk factors that could cause actual results to differ materially from those anticipated, please refer to Part I, Item 1A., Risk Factors, in the Form 10-K.

A disruption in the operation of our DSD distribution system could negatively affect our results of operations, financial condition and cash flows.

We believe that our DSD distribution system is a significant competitive advantage. A material negative change in our relationship with the independent distributors, litigation or one or more adverse rulings by courts or regulatory or governmental bodies regarding our independent distributorship program, including actions or decisions that could affect the independent contractor classifications of the independent distributors, or an adverse judgment against the company for actions taken by the independent distributors could materially and negatively affect our financial condition, results of operations, and cash flows.

We are subject to increasing legal complexity and could be party to litigation that may adversely affect our business.

Increasing legal complexity may continue to affect our operations and results in material ways. We are or could be subject to legal proceedings that may adversely affect our business, including class actions, administrative proceedings, government investigations, employment and personal injury claims, disputes with current or former suppliers, claims by current or former distributors, and intellectual property claims (including claims that we infringed another party’s trademarks, copyrights, or patents). Inconsistent standards imposed by governmental authorities can adversely affect our business and increase our exposure to litigation. Litigation involving our independent distributor system and the independent contractor classification of our independent distributors, as well as litigation related to disclosure made by us in connection therewith, if determined adversely, could increase costs, negatively impact our business prospects and the business prospects of our distributors and subject us to incremental liability for their actions. We are also subject to the legal and compliance risks associated with privacy, data collection, protection and management, in particular as it relates to information we collect when we provide products to customers.

 

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Our Board of Directors has approved a plan that authorizes share repurchases of up to 67.5 million shares of the company’s common stock. At the Board of Directors meeting in November 2014, the Board increased the company’s share repurchase authorization by 7.1 million shares to a total of 74.6 million shares. Under the plan, the company may repurchase its common stock in open market or privately negotiated transactions at such times and at such prices as determined to be in the company’s best interest. These purchases may be commenced or suspended without prior notice depending on then-existing business or market conditions and other factors.

On March 16, 2016, the company announced that we entered into an ASR agreement to repurchase an aggregate of $120.0 million of the company’s common stock.  Under the terms of the ASR, the company purchased 5.6 million shares immediately.  The final number of shares repurchased was based on the daily volume-weighted average stock price over the life of the transaction, less a negotiated discount. The final settlement under the ASR occurred during the second quarter of fiscal 2016 for an additional 0.9 million shares.

During the forty weeks ended October 8, 2016, 6.9 million shares, at a cost of $126.3 million, of the company’s common stock were purchased under the plan.  This included share repurchases under the ASR and other share repurchases.  There were no common stock repurchases under the plan during the twelve weeks ended October 8, 2016.  From the inception of the plan through October 8, 2016, 67.8 million shares, at a cost of $630.4 million, have been purchased.  

 

ITEM 6. EXHIBITS

Exhibits filed as part of this report are listed in the Exhibit Index attached hereto.

 

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

 

Date: November 9, 2016

 

 

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EXHIBIT INDEX

 

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